Though it’s not something that necessarily needs to be done every year by every investor, the end of the year is a great time for portfolio rebalancing. And with the volatile 2018 that we’ve had, particularly in the last three weeks, a lot of investors are likely re-evaluating their portfolios right about now.
Not sure if you need to rebalance your portfolio or not? The guide below will help.
What Is Rebalancing?
Any successful investor knows that diversification is one of the keys to managing risk and achieving long-term returns in the market. The idea behind diversification is to make sure that investments are not too concentrated in a handful of stocks, market sectors or even asset classes. For example, the S&P 500 is down about 7 percent year-to-date in 2018, but investors who own only energy stocks likely took a much harder hit. The Energy Select Sector SPDR ETF (XLE) is down 21 percent year-to-date, tripling the losses of the overall market.
Investors tend to balance their portfolio by spreading risk around via diversification. The problem is that markets are always moving, shifting the ratios of your portfolio on a daily basis. These shifts can unbalance your portfolio over time, creating more risk than you initially intended if you don’t periodically rebalance your portfolio.
Why Is Rebalancing Necessary?
Imagine that you decided back on December 31, 2013, that you wanted 25 percent of your portfolio in energy stocks, 25 percent in materials stocks, 25 percent in tech stocks and 25 percent in health care stocks, and you bought $10,000 worth of each.
The energy sector is down about 34 percent in the past five years. Over the same period, the materials sector is up 10 percent, the health care sector is up 53 percent, and the tech sector is up 75 percent. Given those changes and no rebalancing, your portfolio would now hold about $17,500 in tech stocks, $15,300 in health care stocks, $11,000 in materials stocks and only $6,600 in energy stocks. Those numbers are a far cry from the 25 percent split you originally intended.
Tips for Portfolio Rebalancing
The general idea of rebalancing is to dial back exposure to your top performing stocks (i.e. sell some of your winners) and increase exposure to investments that have been performing poorly (add to losers). Obviously, this is only appropriate if you have a strong conviction in a specific asset allocation strategy. If you do, the end of the year is as good a time as any to make sure that your allocations are still where you want them to be given your personal financial goals and investment timeline.
One thing to keep in mind when performing year-end portfolio rebalancing is the tax implications of selling stocks and other investments. If you’re selling certain stocks to reduce exposure to a particular sector, or if you are selling stocks across the board to reduce your overall exposure to equities, keep in mind that the capital gains taxes on stocks owned less than a year are much higher than those owned for more than a year.
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