Welcome to this month’s Ask the CFP® segment. Today we’ll talk about how we keep your investment portfolio on track over time. This is commonly known as rebalancing.
A long-term investment portfolio should be well thought out and intentional. At Moneta, we believe using target, or model, allocations is the most important part of planning in a long-term portfolio. Together, we evaluate your risk tolerance, time horizon, income needs, and other factors. Then we identify an appropriate target allocation for your portfolio.
At a simple, high-level view, the target allocation is set as a ratio of low risk and return assets – like fixed income – and higher risk and return assets like equities. So, in your overall portfolio, you might have 60% equities and 40% fixed income. Your target allocation can be adjusted based on life events or personal changes, but for this discussion let’s assume it remains constant.
It’s very important to remain aligned with these targets over time so the portfolio stays within your risk tolerance and doesn’t become too aggressive or conservative.
Using the example of a portfolio targeting 60% equities and 40% fixed income, let’s say there’s a year that equities are doing exceptionally well. That may change your portfolio weighting, making the portfolio more aggressive than you are comfortable with. We would then rebalance your portfolio to avoid this drift away from your target.
Rebalancing can occur in a number of ways depending on whether you’re in a money-saving stage or retired and using portfolio funds to meet living expenses.
The percentage your allocation can differ from its target should always be limited. We call this a tolerance band. If market performance causes the allocation to change beyond the tolerance band, we rebalance and move the proceeds accordingly to stay within your target.
Tolerance bands are usually between 5% and 10%. You don’t want a tolerance band of 1% because the market can move that much in a single day. Rebalancing too often can potentially cause tax consequences or excess transaction fees. On the other hand, you also don’t want a tolerance of 25% because it could significantly change your portfolio risk.
We also keep taxes in mind when rebalancing. As much as possible, we rebalance to avoid incurring extra income on your tax return.
Rebalancing your investments is a key factor in reaching your long-term financial goals. This takes the emotion out of the process and helps us sell high and buy low, funneling dollars into assets that have room for growth. If you have a question on this topic, or a suggestion for a future ask the CFP segment, please send it to mpeek@monetagroup.com
Thanks for watching and we’ll see you next time.
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