After years of upward movement, there’s a good chance your portfolio took a hit in 2018.
But whether your returns were up or down, it’s a good time to take a close look at your investments to make sure they’re not out of whack. To rebalance.
It starts with asset allocation.
Asset allocation is what percentage of your portfolio you’ve invested in stocks, bonds, international investments and other areas.
“As time passes and the capital markets move up and down, the weightings of the assets can get out of sync with the original percentage allocation,” said Claudia Mott, a certified financial planner with Epona Financial Solutions in Basking Ridge. “Rebalancing brings the portfolios holdings back into alignment with the desired weightings.”
Here’s what you need to know to keep your portfolio working for you.
Why asset allocation matters
The right asset allocation for you depends on your goals, your time horizon and your risk tolerance.
If you’re closer to retirement, you’re going to need a more conservative allocation. If you’re just starting out, you have time to let the markets recover should there be a downturn.
But asset allocation isn’t a one-time process. As you get older and closer to your goals, you’ll need to update your allocation to reflect those changes.
Having a target allocation will help you manage risk and return over a long period of time, said Diahann Lassus, a certified financial planner and certified public accountant with Lassus Wherley, a subsidiary of Peapack-Gladstone Bank in New Providence.
She said too many investors pick investments, whether they are mutual funds or stocks, based on a one-at-a-time process.
“What they end up with is a disorganized portfolio because they didn’t start with the foundation or plan,” she said. “It is comparable to trying to build a house without an overall design or architectural plan. You end up with many good pieces but they just don’t fit together.”
You need an asset allocation framework in place so over time, you can adjust and rebalance to stay in line with your goal allocation.
Trying to rebalance without a predetermined asset allocation means that you aren’t investing within the context of your goals and long-term plans, said Gene McGovern, a certified financial planner with McGovern Financial Advisors in Westfield.
“Instead, you’re likely to be responding to recent changes in market performance or volatility,” McGovern said.
Asset allocation also helps you from letting emotions run your portfolio.
“Nobody wants to sell a stock that’s doing well,” said Jerry Lynch, a certified financial planner with JFL Total Wealth Management in Boonton. “When we work off models, it’s easier and not emotional. You just stick to your percentage.”
Creating your asset allocation
If you’re a do-it-yourselfer and you’re not working with a financial advisor, here’s what you can do.
Start by deciding how much you should have in stocks and how much you should have in bonds.
For example, you might find that a traditional balanced portfolio of 60 percent stocks and 40 percent bonds is appropriate, McGovern said.
If you’re older or more conservative, the portfolio could be tilted more heavily toward bonds and cash, while if you’re younger or more aggressive it could weight stocks more heavily, he said.
Then you’ll need to break down each of those categories to further diversify your dollars.
On the stock side, consider how much to invest in U.S. large caps, U.S. small caps, international, emerging markets, real estate and other asset classes.
“It takes time to develop a plan but it the most important part of managing your investments over time,” Lassus said.
It can be a big job, so consider modeling your portfolio after some that are readily available online.
The American Association of Individual Investors provides a number of asset allocation models which show how a portfolio would be distributed not only across equity and fixed income investments, but within each of these broad categories, Mott said.
Still another option is to rely on target-date mutual funds, which automatically change asset allocation based on a target date. These get more conservative over time, Lynch said, so you can be sure the investment isn’t too risky for your goals.
“They are in no way perfect but it is better than slapping a bunch of funds together,” Lynch said.
How often should I rebalance?
There is no one right answer to how often you should rebalance.
Mott said for most investors, reviewing their portfolio allocation once a year and making adjustments is an appropriate way to rebalance.
“This enables market trends to be captured over the course of a 12-month period and prevents the portfolio from being whipsawed by changing too quickly,” she said.
McGovern and Lynch agree that once a year is generally sufficient for rebalancing.
“This is more of an art then a science,” Lynch said. “I like annually as it gives the market the time to grow, and then we sell off some of the gains and buy into the areas that did bad.”
But in a volatile market, Lynch said, he might rebalance a few times per year.
Let’s dig a little deeper.
Lassus said the best way to manage the risk is to make sure your allocation stays close to the targets you have established.
“Rebalancing periodically is a discipline that forces you to buy low and sell high which is definitely what we try to do as investors,” she said. “Rebalancing actually means taking profits from those investments that have done well and buying those investments that haven’t done as well.”
She said there several different approaches to rebalancing.
The first is to establish a timeframe for review, she said, whether you choose quarterly, semi-annually or once a year.
If your portfolio is more aggressive, you may want to review quarterly.
“The critical thing to remember is that the review is to determine if there is a need to rebalance – not necessarily to rebalance,” she said.
The second method is to establish parameters or bands that will be a trigger for you to take action, Lassus said.
She offered this example. Let’s say you have an asset class with a target to be 30 percent of your portfolio. Then it does really well or poorly during a period of time.
“If you set your parameters at plus or minus 20 percent, that means this asset class value has a range of 24 to 36 percent before you would either buy more or take profits,” Lassus said. “Bands are typically set between 10 and 20 percent.”
The third method would be to use a combination of the two with a periodic review in combination with established bands for determining when to rebalance, she said.
Don’t forget about taxes
If you’re looking at retirement accounts, you won’t have to worry about creating a taxable event when you rebalance.
But if you’re looking at taxable accounts, the sale of any investment could create a short or long-term capital gain or loss, and that will have an impact on your tax bill, Mott said.
“Capital gains can be offset losses but there are limits,” she said. “While taxes should be a consideration, they should not prevent the changes that may be necessary to keep the portfolio in alignment with its desired goals and risk profile.”
So how much tax are we talking about?
Short-term capital gains – those from investments held for up to one year or less – are taxed at the same rates as ordinary income, McGovern said. These range from 10 to 37 percent, depending upon your income.
Long-term capital gains, by contrast, are taxed at rates from zero to a maximum of 20 percent, depending on your taxable income and filing status, McGovern said.
“Thus, when selling assets from a taxable account that have performed well during rebalancing, you’ll want to make sure to sell those held for more than one year,” he said.
Remember cost basis
Lassus said it’s important to make sure you have accurate cost basis information before selling an investment in a taxable account. This means having a record of all purchases over time.
“If the purchases are recent, the broker will have this information, but if it is a holding you have had for a long term or it was a gift, you may need to do some research to verify the cost and purchase dates,” Lassus said.
You can learn more about how to research cost basis here and here.
Avoid common mistakes
The advisors we talked to said there are some common mistakes investors make when rebalancing.
Don’t rebalance too frequently or make trades in response to market moves, Mott said. Instead, stay the course and ride out the ups and downs.
Lassus said one of the biggest problems for individual investors is not recognizing that many of their mutual funds are invested in the same stocks.
“They may believe they are well diversified but really aren’t,” she said. “For example, they may invest in four or five mutual funds that invest in U.S. large cap stocks like Apple or Johnson & Johnson. If you look at the fund holdings, you see that you aren’t getting much diversification at all.”
It goes back to that simple saying about not putting all your eggs in one basket, she said.
What’s ahead in 2019?
Market watchers agree the new year will be a volatile one.
After a long bull market and relative calm in the markets, McGovern said, we appear to be in for a period of sustained volatility, at least in the near term, as well as potentially lower future returns from stocks and bonds than we’ve experienced historically.
“Investors should realize that this is the norm with markets and not a cause for immediate concern, especially if you are comfortable with your overall asset allocation,” he said.
Long-term buy-and-hold investors who periodically rebalance their portfolios should largely ignore day-to-date market conditions, McGovern said.
He said if your time horizon is 30 or 40 years, a short-term dip in the market, even a substantial one, means very little.
Lassus said with the expected volatility, it’s important to make sure your portfolio is not too narrowly focused.
“There is an ongoing risk of financial markets being moved by headlines so it is important to focus on the long-term investment and not get pulled into making short-term decisions,” Lassus said. “Thinking short term and trying to time markets is a really good way to miss out on upward movements when they occur.”