The Why and How of Rebalancing

75% stock/25% bond.

That's the current asset allocation of a portfolio that was 50% stock/50% bond at the outset of the current market rally—which stretches back to March 9, 2009. If the hypothetical investor had added more money to stocks during this period, as investors are often inclined to do when stocks are going up, the equity allocation would be even more lofty.

By any reasonable standard, it's time to rebalance—to cut down the portfolio's equity weighting in an effort to reduce risk in the portfolio before the market does it.

Yet many investors have been reticent to rebalance. Inertia is an incredibly powerful force, and selling what's been working best in a portfolio runs counter to human instinct. We want to send more money to the winners in our portfolios, not take away from them.

And let's not forget the elephant in the room, the so-called TINA ('There is no alternative') argument. The alternatives to stocks—bonds and cash—don't particularly compel right now. Yields are still meager, while bonds court interest-rate risk.

Yet rebalancing can deliver some powerful benefits—risk reduction, cash-flow production, and/or possible returns enhancement, depending on the type of rebalancing investors engage in. Nor does rebalancing need to be a complicated, spreadsheet-assisted affair. The following steps can help investors rebalance quickly and painlessly.

Step 1: Determine what the investor is trying to accomplish.
The first step in the rebalancing process is deciding what the investor would like to achieve with rebalancing. That, in turn, can help the investor identify what type of rebalancing she can engage in.

The goal: Volatility and/or risk reduction 
Rebalancing prescription: Asset-class rebalancing 
If reducing risk in the portfolio is top of mind—the investor is concerned about market valuations, the investor gets jittery during falling markets, and/or the investor is getting ready to retire—traditional rebalancing among asset classes, such as reducing stocks in favor of bonds, can be the right strategy. This type of rebalancing tends to reduce risk but won't necessarily enhance returns.

That's because periods in which stocks outperform bonds (risk-reduction opportunities) outnumber periods in which bonds outperform stocks (returns enhancement opportunities).

In light of the fact that risk reduction is the main benefit of this type of rebalancing, very volatility-insensitive investors needn't make too big a deal of it. If during the financial crisis or periodic market blips an investor favored buying opportunities rather than fleeing the falling market, rebalancing isn't essential.

Life stage is important here, though. Even for notably calm and collected 62-year-old equity investor who is closing in on retirement, rebalancing is probably a good idea. That's because new retirees with big equity weightings are particularly vulnerable to bad returns at the outset of their retirements: If they're actively spending from their equity portfolios as they're declining, that has a demonstrated negative effect on the portfolio's sustainability. Investors should use anticipated portfolio spending to help determine the appropriate allocations they should have to stocks, bonds, and cash. For investors who don't have enough of the safe stuff, trimming stocks and moving the money into bonds and cash is a smart strategy.

The goal: Return enhancement 
Rebalancing prescription: Intra-asset-class rebalancing
If enhancing returns, rather than reducing risk, is a key goal, rebalancing within asset classes can be a beneficial strategy. The basic idea is that investment styles zip in and out of favor; periodically pulling back on those that have performed well, as large-growth stocks have recently, and sending money to those asset types that have underperformed, like small value, can build a contrarian element into a portfolio. That has the potential—but not the guarantee—to enhance returns.

Investors can also consider rebalancing among geographies. While foreign stocks have performed well so far in 2017, thanks in no small part to appreciating foreign currencies relative to the dollar, in years past they've been clobbered by U.S. names. That sort of persistent underperformance can provide smart rebalancing opportunities. Investors can further fine-tune their rebalancing efforts by rebalancing between developed- and developing-markets stocks.

The goal: Cash-flow production
Rebalancing prescription: Asset-class and intra-asset-class rebalancing
Rebalancing can serve another valuable role for retirees: It can help them find cash for living expenses. With yields still low across asset classes, many retirees have scrambled with traditional income-centric strategies. One recommendation is to not focus disproportionately on income production when building an in-retirement portfolio. Rather, retirees can be content with the 2%-3% organic yield on a traditional, non-income-focused portfolio, then periodically rebalance to harvest any additional living expenses needed. Today, retirees in search of income can find cash hiding in plain sight in the form of appreciated equity holdings. They can source their cash flows and/or fulfill required minimum distributions by focusing on their most highly appreciated equity holdings—probably those in the large-growth square of the style box.

Step 2: Find your current asset allocation and sub-asset-class exposures.
Once investors have determined their rebalancing goal and what type of rebalancing they plan to engage in, they should take a look at their current portfolio allocations and actual exposures.

Step 3: Compare your allocations to your benchmarks.
Armed with their portfolio's true exposures, investors can then compare them to their targets. All investors should be operating with some type of blueprint for their portfolios' asset-class exposures. A financial advisor can help investors customize their asset mix based on their unique situation.

Investors who are engaging in rebalancing within asset classes will need some benchmarks, too. A total market index can help gauge style exposures: Today, most such indexes hold roughly 24% in each of the large-cap squares of the Morningstar Style Box, 6% in each of the mid-cap squares, and 3% apiece in the small-growth, -blend, and -value boxes.

If an investor is trying to manage a portfolio's geographic exposures, the U.S. currently constitutes about 53% of the globe's total stock market value. Meanwhile, roughly 9% of the globe's market cap is designated emerging and the remainder developed.

Step 4: Focus on tax-sheltered accounts
Selling appreciated securities can lead to tax consequences if done within a taxable (i.e., non-retirement) account. That's why it makes sense to concentrate any rebalancing efforts within tax-sheltered accounts, where investors won't face tax consequences for switching things up. While it is not advisable to get in the habit of over-trading in a 401(k) or other company retirement plan, where investors can dodge both tax and transaction costs when they make trades in such accounts, they may also be able to do so within their IRA. 

If an investor’s taxable account looks particularly problematic—for example, it has way too much equity risk and the investor plans to retire soon—the investor should mind tax costs before scaling back highly appreciated positions. Investors in the 10% or 15% tax bracket currently pay a 0% capital gains rate, but everyone else is on the hook for capital gains tax. In lieu of triggering a tax bill, investors may want to address this asset-allocation issue by steering future contributions into the underweighted areas of their taxable accounts. Alternatively, they can use the specific share identification method when harvesting winners, earmarking high-cost-basis lots for sale rather than lower-cost-basis ones.

Step 5: Identify specific candidates for pruning and additions.
Finally, investors should identify specific holdings for pruning and addition. Even if the main rebalancing goal is to reduce risk by scaling back equity exposure, investors can also be savvy about which stock holdings they scale back on and which they add to. As noted above, large-growth stocks have enjoyed a strong runup so far in 2017 and therefore may be particularly ripe for pruning. Meanwhile, the tamest bonds (short-term and high-quality) have performed the worst.

Investors can also use rebalancing to address trouble spots in a portfolio—for example, trimming the stock that represents an overly concentrated position, or selling the equity fund that has seen a succession of portfolio managers in recent years. In so doing, investors can reduce risk and improve portfolio fundamentals at the same time.

This article contributed by Christine Benz, Director of Personal Finance with Morningstar.

This is for informational purposes only and should not be considered financial planning advice.

Diversification does not eliminate the risk of experiencing investment losses. Holding a portfolio of securities for the long-term does not ensure a profitable outcome, and investing in securities always involves risk of loss.

Past performance is no guarantee of future results. Stocks are not guaranteed and have been more volatile than the other asset classes. International investments involve special risks such as fluctuations in currency, foreign taxation, economic and political risks, liquidity risks, and differences in accounting and financial standards. Debt securities are subject to credit/default risk, which is the risk associated with the issuer failing to meet its contractual obligations either through a default or credit downgrade.