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Annual Rebalancing Steps To Consider This Tax Season

As you begin to receive 2023 year-end statements, it will be tempting to focus on how well the markets performed. But especially because of this year’s solid market performance, it would be a safe bet that many investors need to consider rebalancing, because they might now be overweight or underweight certain asset classes – and therefore positioned in a way that is inconsistent with their risk tolerance and goals.

December is the Time to Plan

The reality is that the market moves all the time and your investments should evolve with the changes. It is important to rebalance your investments regularly, at least on an annual basis.

In simple terms, rebalancing is the process of reviewing and then possibly changing your current mix of investments in your investment accounts. For example, as you settle into your career and still have decades until your retirement, you might decide that your risk tolerance can increase, thereby allowing you to invest more in stock and less in bonds. Or your investments grow in some categories from your original allocation, and you need to get the mix back to where you started.

Without rebalancing, some components of your investment assets can become too large (or too small) a part of your total portfolio, exposing you to more risk than you can afford. Below are a few steps that we can use as we evaluate whether you should rebalance.

Step One

We need to assemble all the information about all of your accounts. Rebalancing – sometimes referred to as reallocating – requires that we examine your entire portfolio – not just what you might have invested with my firm.

This includes gathering statements from all your bank accounts, all retirement plans, all brokerage accounts and other investment related accounts, such as life insurance. In a perfect world, as your financial advisor I would receive this information throughout the year, but there might be additional investment-related accounts that you forgot to send.

The key is that we have a complete picture of your investment health, so that we can ensure your investments are allocated in a way that is consistent with your risk tolerance as outlined in your personalized financial plan.

Step Two

Next, we will simply break down your overall positioning into four categories – cash, bonds, stocks, and other (we will expand upon each of these four categories further, but we can discuss that when we arrive at that point).

For our purposes, we will consider bond mutual funds and individual bonds in the “bonds” category and we will put individual stocks and stock mutual funds in the “stocks” category. Real estate or other non-stock and non-bond investments will go into a fourth category.

We will add up each category of items separately and divide that amount by the overall total. This will give us your current ratio of how your assets are allocated.

Step Three

Then we will discuss and decide what mix is right for you. You should know, however, that this step is a little more difficult than it sounds, because every individual is different. Sure, there are rules of thumb that we can use, but in the end, deciding on an asset allocation is a very personal decision.

The right asset allocation for you depends on factors like your age, the number of years until retirement, your income, your savings, your debt, your health, and your housing status, and more. And of course, we need to apply the same factors for your spouse and consider your children, including big-ticket expenses like college education.

The point is that your asset allocation must change as time passes. Young people usually have a higher risk tolerance, while older investors facing retirement should have more conservative investments in their portfolio. So, you can tell me that nothing has changed from one year to the next and I’ll respond that we still need to look at your asset allocation every single year (unless you’ve figured out a way to stop aging…).

For example, a single woman at 25 may have a ratio of 90% stocks, 5% real estate, and 5% bonds. When she reaches 40, she might want to have a lower-risk exposure, say, 70% stocks, 20% real estate, and 10% bonds. Around age 55, we might adjust the ratio to 50% stocks, 20% real estate, and 30% bonds.

Please remember that these ratios are only examples and are not a recommendation at all – each individual should determine the appropriate ratio for his or her own personal situation with their financial advisor.

Step Four

We will then adjust your actual ratio to match your ideal ratio, as outlined in your financial plan. But it won’t be a matter of just trimming a little here and adding a little there – we need to take a lot of factors into account – including tax consequences – before we adjust.

The good news is that I can run lots of different scenarios and hypotheticals with my financial planning software before we make real rebalancing adjustments.

Final Thoughts

Sounds painless, right? In theory it is, but it can be a bit overwhelming the first time we do it. But with anything, the process gets easier each time.

Categories: The Market

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