Rebalancing Your Portfolio Without Taking a Financial Hit

In writing about the lies that financial advisors sometimes tell, the subject of rebalancing your portfolio came up. Obviously, rebalancing your investments to track your desired asset allocation is an important thing to do. When thinking about how often (and how) to do it, though, you need to keep costs in mind.

On the one hand, you need to consider transaction costs. If you’re just holding a bunch of no load mutual funds, you’re in the clear, but… If your portfolio includes individual stocks, ETFs, and the like, then you’ll need to be cognizant of the costs — unless, of course, you’re getting free trades from someone like Zecco.

Another concern is taxes. If you’ve decided to rebalance your retirement portfolio, then this is a non-issue. But if you’re re-balancing investments in a taxable account, selling shares that have appreciated will create a capital gain, thereby exposing you to taxes. Thus, you’ll need to think very carefully about whether or not getting your holdings back in line is worth the tax hit.

Perhaps the easiest workaround for avoiding taxes when rebalancing is to simply adjust your contributions such that you’re buying more of the lagging portion of your portfolio going forward, as opposed to selling your winners to buy the laggards. While this is a less immediate method of rebalancing, it’s equally effective, and totally pain free when it comes to taxes.

6 Responses to “Rebalancing Your Portfolio Without Taking a Financial Hit”

  1. Anonymous

    Brad… I agree with what you said, making contribution adjustments to bring asset allocations in line does defeat the purpose of re-balancing.

    Re-balancing a portfolio acts like a buy/sell discipline. You are trimming the fat off of investments that have performed well and adding to starved areas that have underperformed.

    If you’re a student of the market then you know many of these asset classes, sizes and styles are cyclical. What hasn’t done well, may be more likely to going forward.

    For instance, if the small cap portion of your portfolio dramatically underperforms the large caps, you sell a little of what has done well (sell discipline) and buy something that’s potentially undervalued and poised to have better relative performance in the short term (buy discipline).

    As far as taxes, i think that should be a secondary concern. Clients often ask me that question, saying they don’t want to sell something because of the tax consequence… then the sector that had a nice run up, gives back a portion of the gains. We no longer have a tax problem because we never locked in the gain. Taxes should be viewed as secondary.

    Commissions… well Zecco makes sense for as long as they keep it free. That will probably change at some point. I think the same thinking that applies to re-balancing should apply here. In my case, clients don’t pay commissions, its all included in the wrap fee.

    At the end of the day, re-balancing is the way to go. The frequency is up to you. I prefer twice a year, although once may work for many… a concession to those worried about taxes and commissions:)

  2. Anonymous

    I’ve read some who believe that simply making contribution adjustments to bring asset allocations in line partially defeats the purpose of re-balancing. The argument being that if an asset class is over-represented that means that it has been performing well and the price has increased. However, if an asset class is under-represented that asset class has not been doing as well. By selling the over-represented assets and buying the under-represented assets, it is an automatic form of buying low and selling high. Obviously the assumption is that the under-represented asset class will catch-up and/or the over-represented asset class may have risen too high and will fall back down to some extent.

    Consequently, I have heard that you should actually rebalance by buying and selling, not simply changing contribution allocations. What are your thoughts?

  3. Anonymous

    I’m aiming to use the 2008 0% on capital gains rule to sell off a bunch to rebalance. I’ve been planning for it, and will be doing everything under my power to get into the 15% tax bracket.

  4. Anonymous

    Buying more of a certain fund/stock is one way but it will probably be a very slow process once your portfolio gets to a bigger size. Sometimes you just have to bite the bullet and take the commissions.

  5. Anonymous

    Of course, this could also be coupled with annual checkups–to make sure that the contributions adjustment did what you actually wanted (because of stock prices and whatnot).

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