Invest along with me! Step 3: Rebalancing

Welcome back to the next edition of “Invest along with me!”. If this is your first time visiting this website, be sure to check out the following posts first:

How to Invest in Stocks for 8% or Higher Returns

Why Everyone Needs a Roth IRA & How to Open One

Invest along with me! Step 1: Funding my IRA for 2020

Invest along with me! Step 2: Buying stocks

Last week, we learned about asset allocation and how to actually buy stocks in our IRA/Roth IRA. This week, we’ll learn about rebalancing and why it’s important.

What is rebalancing? 

Rebalancing is bringing your portfolio back to its original asset allocation mix.

For example, an investor’s asset allocation is 60% stocks and 40% bonds; however, due to the recent growth in stocks over the previous year, stocks now account for 80% of this investor’s portfolio and bonds are only 20%. Rebalancing is necessary to bring the asset allocation back to it’s original mix.

Since we’ve just bought funds last week and the amount invested is relatively small, there likely won’t be much movement in our portfolio yet, so rebalancing isn’t necessary at this time. However, six months to one year from now, that could be different. The stock portion of our portfolio could grow much faster than our bond portion (or it could decrease a lot more than bonds), and throw off our asset allocation. This causes our investments to be out of line with our investment goals, and could put us in more risk than we are comfortable with or had planned for.

How do you rebalance?

There are three ways to rebalance:

1. You can sell off investments from over-weighted asset categories and use the proceeds to purchase investments for under-weighted asset categories.

This method is fine if you are buying and selling within your Roth IRA. If you are doing this in a regular brokerage account, it can result in tax consequences.

2. You can purchase new investments for under-weighted asset categories.

In the example above in which stocks now account for 80% of the portfolio instead of the targeted 60%, the investor would buy more bonds to increase its share of the portfolio.

3. If you are making continuous contributions to the portfolio, you can alter your contributions so that more investments go to under-weighted asset categories until your portfolio is back into balance.

For example, if you didn’t have the full $6,000 to max out your Roth IRA, your first contribution can be in the amount of $1,000. If your asset allocation is 60% stocks and 40% bonds, you would buy $600 worth of stocks and $400 worth of bonds. Lets say two months go by before you can contribute another $1,000 to your Roth IRA, and now the stocks portion of your portfolio is worth $650 and bonds account for $405. Combined, your portfolio is worth $1,055. $650 in stocks out of a portfolio value of $1,055 means stocks now account for 61.6% of the portfolio ($650/$1,055), while bonds account for 38.4% of the portfolio ($405/$1,055). With the next $1,000 that you contribute, you would want to allocate $583 towards stocks ([($1,055+$1,000)*60%]-$650) and $417 (=$1,000-$583) towards bonds to bring the allocation back to 60%/40%. You would repeat this calculation with every contribution.

Why rebalancing is important

Rebalancing takes the emotions out of investing and keeps you in line with your investment goals. It forces you to sell high and buy low–which can be difficult to do especially if stocks are rising (psychologically, everyone wants to jump in when the market is hot, but that means you are buying at a high–you really want to be doing the opposite). By sticking to your asset allocation, you are selling while it’s high and buying when it’s low.

When to rebalance

If you are not making continuous contributions to your portfolio and rebalancing with each additional contribution, rebalancing your entire portfolio at least once a year is sufficient. In my case, since I’ve already maxed out my IRA contribution for 2020, I would rebalance when I invest another $6,000 for 2021 (assuming the contribution limit doesn’t increase).

Want an easy way to track your investments?

Sample Personal Capital dashboard when you log on from a desktop.

I use Personal Capital, a FREE app, to track all of my investments. There’s a feature that tells me where my asset allocation currently stands and what my target asset allocation should be. If you want to support this website, you can use my referral link (https://share.personalcapital.com/x/BxilsN) and we’ll each get a $20 Amazon gift card after you create an account and link one qualifying account (e.g. taxable brokerage, 401k, IRA, 529, etc.).

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