DR 052: A Step-by-Step Guide to Rebalancing Your Investments

In the last podcast, we talked about why rebalancing your investment portfolio is important and how to create a rebalancing plan. Today we are going to walk through step-by-step how to actually rebalance your retirement and other investments.

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As we discussed in the last podcast, you can rebalance your assets based on frequency, threshold, or a combination of the two. You might, for example, rebalance your investments every six months (frequency), you might rebalance them when they get more than 5% away from your original asset allocation plan (threshold), Or you could check them every six months, but only rebalance if they’re 5% or more outside your plan (frequency & threshold).

4 Rebalancing Factors to Consider

Whether you're using a frequency approach, a threshold approach, how do you actually rebalance your assets? There are four factors that should go into answering that question.

Complexity

One factor is complexity. As you start to save for retirement, you may have a 401(k) or multiple 401(k)s. You may have more than one IRA, and you may have money invested in taxable accounts. You might have a spouse who also has 401(k)s and IRAs. So all of this can get quite complex.

So when looking at the ways that you can rebalance, simpler is better. There are ways to avoid unnecessary complexities, which we'll talk about further down the page.

Taxes

If you have money invested in taxable accounts, selling investments may trigger capital gains tax. You need to be mindful of the tax consequences of rebalancing.

In the vast majority of cases, you should be able to rebalance your investments without triggering taxes. There could be some exceptions, but most investors should be able to avoid taxes. In my case, my wife and I have significant investments in taxable accounts outside our 401(k)s and IRAs, but we've been able to avoid most capital gains taxes when we rebalance.

Costs

Costs primarily hit folks in taxable accounts, but this isn't always the case. With a 401(k), you can typically buy and sell funds without paying fees. Some mutual funds, however, do assess fees for frequent trading.

With my IRAs at Vanguard, I can buy and sell Vanguard mutual funds and ETFs without any costs, generally. Sometimes funds will charge you costs when you buy or sell that are added to the fund itself. In other words, the mutual fund company isn't profiting from this. Instead, the money goes back into the mutual fund to prevent a lot of short-term buying and selling. So even with a Vanguard-type fund, be sure you're aware of potential costs.

With taxable accounts, if you're investing in individual stocks and ETFs, you'll probably pay brokerage fees, for example. Depending on how complex your investments are and how many different stocks and ETFs you own, the costs could be significant. This is when a discount online broker can really pay off.

Fund options

This is a particular issue with 401(k)s. I've had some 401(k)s that offered great investing options. In some cases, however, they offered very few options at all. So if you have a 401(k) that only has one really good option, take that into account. If you sell shares of the only decent mutual fund in your 401(k) to move the money to a different asset class, you may be forced to invest in an expensive fund.

This is generally just a problem with 401(k)s because you can open an IRA pretty much wherever you want. At a place like Vanguard or a brokerage, you can invest in stocks, bonds, ETFs, mutual funds - you've got a lot of options. But within your 401(k), you may be limited. So that's a factor to consider as you rebalance your asset allocation across all your accounts.

Options for Rebalancing

I'm going to give you a few options for rebalancing, in the order I go through them myself. Hopefully, I can rebalance with just option one, since it's the easiest. But, if not, I work my way down the list.

1. Set future contributions

You can rebalance your portfolio in five minutes by simply redirecting future contributions. For example, in 2013, we all know there was a major run-up in stocks. The S&P 500 was up 32%. So most people needed to rebalance by moving investments from stock funds into bond funds.

The first and easiest way to do that is to set future contributions. For example, in 2014, all of my contributions to my 401(k) are going to a bond fund, so that avoids any taxes and other costs, and it’s very simple. I can log into my 401(k) and change my future contributions in less than five minutes.

This approach to rebalancing, of course, doesn't happen immediately. It will take some time to get my portfolio back into line with my target asset allocation plan because I'm contributing relatively small amounts to my 401(k) each month. But over the course of the year, it should be enough to get my portfolio back in line with my target asset allocation.

If actual investments have deviated significantly from an asset allocation plan, this approach may not be effective. As a rule of thumb, I use this approach if it will realign my asset allocation within 12 months.

2. Rebalancing within retirement accounts

If future contributions won't rebalance your portfolio quickly enough or if you are no longer contributing to retirement, the second approach is to rebalance within your retirement accounts.

This goes back to the taxes and costs. You can rebalance a tax-deferred account without triggering capital gains taxes. This approach works with both traditional and Roth accounts. Generally, there are no or little other costs involved as well.

I've found that we can almost always rebalance our portfolio using one or a combination of these first two approaches.

3. Redirecting interest and dividend payments

If you've exhausted options one and two, then you may need to include your taxable accounts in rebalancing. One way to rebalance taxable accounts without triggering additional taxes is to redirect interest payments from bond funds and dividends from stock and stock funds.

Instead of automatically reinvesting this income, have interest and dividends swept into a cash account associated with your mutual fund or brokerage. Then, use the money to rebalance your investments based on what you need at the time.

In a taxable account, interest and dividends are taxable, even if they're reinvested. Depending on your tax situation, you'll likely have to pay taxes on these amounts whether you reinvest them or not. Directing this income to investments that will rebalance your portfolio should not increase your tax liability. There may be, however, brokerage fees associated with investing this income.

4. Selling and buying

Now we’re down to the last resort. If you’ve exhausted your other options, you may need to actually sell investments and buy other investments through your taxable accounts.

Thinking over the last 20+ years I've invested, I don't think I've ever had to do this. But if I had to, the first thing I would look at is whether I have assets that are at a loss right now. By selling investments at a tax loss, I would avoid a tax bill and may even have a write off on my return.

If I didn’t have investments at a loss (and I don’t), I’d look for assets that had very little gains. While selling these assets would trigger capital gains, it helps minimize the tax hit. If you are uncertain as to your cost basis on an investment, this information is tracked by most if not all brokerages. I know from experience that Vanguard, Scottrade, and OptionsXpress all track the cost basis of my investments.

The other thing to look at is whether the gains on investments you might sell are short-term and taxed at the ordinary income rates, or if they’re long-term gains. Gains from investments you’ve held for more than 12 months will get hit with capital gains. Since capital gains are taxed at a lower rate, generally, you’ll want to sell the longer-held assets first. Again, most brokers will have this information available to you in your account.

5. Automatic rebalancing

This option doesn't really fit into the first four, and it doesn't apply to all your investments. But it can make rebalancing easier and can help keep your assets closer to your original allocation plan.

If may have a 401(k) or an IRA with relatively little money. I have a Roth rollover IRA with a balance of about $3,000. Working account into my overall asset allocation plan is a chore. Rebalancing it is equally annoying.

One option is to put that account in a Vanguard Target Date Retirement Fund that is automatically allocated between stocks and bonds. Mine, for instance, is in the 2030 fund. The fund automatically rebalances, so I don’t have to worry about it from an asset allocation or rebalancing perspective.

That’s just one way to deal with accounts that are small in amount relative to your total savings. Other options include using Betterment or Motif Investing, both of which make asset allocation and rebalancing very easy. It makes your total asset allocation plan easier to deal with, and you can basically ignore it when it comes to rebalancing because Vanguard (or Betterment or Motif Investing) does it automatically.

The first time you rebalance your investments can be intimidating. But once you do it, you’ll get the hang of it. Do your best to stick within the first two options, and use that fifth option for accounts with relatively little money. For the majority of people, these options will get the job done.