When and How to Rebalance

When and How to Rebalance

With the S&P 500 delivering another strong year (up 13.89% in 2014), now is probably a good time to rebalance your portfolio. Most likely your ratio of equities to fixed income has increased above your target, which means you are taking on more risk than your original target level.

Why Rebalance

The biggest reason to rebalance is to keep the riskiness of your portfolio in check. After a few years of high equity returns without rebalancing, your portfolio will now be overweighted in equities and underweighted in fixed income.

This is okay as long as equities continue to perform well, but there is always a chance that equities will have a bad year, like in 2008 when the S&P fell by 37%. If you have the majority of your investments in equities, this may be hard to ride out. The worse thing you can do is sell at this point, but that is what many people tend to do when equities fall hard.

Instead, you’ll want something to temper the fall, and that will be the fixed income portion of your portfolio. Taking time each year to rebalance at least your equity and fixed income proportion will help control the riskiness of your portfolio.

How to Rebalance

To set-up a rebalancing schedule, you’ll need to have a target allocation for each asset class and a target band with your minimum and maximum allocations.

One helpful rule to follow when setting up your minimum and maximum allocation is the 5/25 rule. The 5/25 rule sets the target band for the maximum and minimum allocation level at either an absolute +/- 5 percent of the target allocation or 25 percent of the target allocation, whichever number is less. Here’s an example for a simple portfolio with 40% fixed income and 60%:

Asset Class Minimum Allocation Target Allocation Maximum Allocation
US Large Caps 25% 30% 35%
US Small Caps 7.5% 10% 12.5%
International Developed 11.25% 15% 18.75%
International Emerging 3.75% 5% 6.25%
Total Equities 55% 60% 65%
Nominal Bonds 15% 20% 25%
TIPS 15% 20% 25%
Total Fixed Income 35% 40% 45%


In the case above, the absolute 5% rule is used for US large caps since 25% to 35% (plus and minus 5%) is a smaller band than 22.5% to 37.5% (plus and minus 25% of 30%). The 5% rule is also used for Total Equities, and Total Fixed Income. The relative 25% rule is used for the US Small Caps, International Developed, and Emerging Markets. The minimal and maximum amount for Nominal Bonds and TIPS is the same for both rules.

Once a year review your total investments across all accounts and determine the total amount you have invested for each asset class. If you are outside the minimum/maximum bands, then sell the asset class you are overweighted in and buy the asset class you are underweighted in.

Other Tips When Rebalancing

  • Rebalance in your tax deferred accounts first to avoid any capital gains.
  • The most important allocation for the risk management of your portfolios is the equity to fixed income allocation. If transaction costs and capital gains cost are too high to rebalance in the more narrowly defined asset classes (such as small cap, emerging markets, etc.), then consider rebalancing only so the total equity and total fixed income allocation is within your target band.
  • Rebalance when you have new cash to invest during the year. Use the new cash flow to stay within your target bands by adding to your underweighted classes.


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The content on this post is for information purposes only and is not intended to provide individual tax or financial advice. Readers are advised to consult financial or tax professionals for specific information regarding your individual situation. Opinions expressed herein are solely those of Balance Financial Planning, LLC, unless otherwise specifically cited. The content is developed from sources believed to be providing accurate information.

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