JPMorgan Chase – Should You Or Shouldn’t You Rebalance Your Investment Portfolio?
When the stock portion of your investment portfolio has increased significantly in value, conventional wisdom recommends rebalancing your portfolio to match your target asset allocation.
Some investment advisors even recommend selling high-flying stocks that have grown enough to dominate your portfolio’s performance.
But, conventional wisdom isn’t always right. There are good arguments for and against rebalancing your investment portfolio.
Why You Should Rebalance
An asset allocation provides a target mix of categories of investments, such as stocks and bonds, to balance investment risk and return on investment. The specific asset allocation is based on your risk tolerance.
As stocks appreciate in value, your investment portfolio is no longer in sync with the target asset allocation. This can increase your investment risk, since it leaves you overexposed to a particular asset class or stock.
Rebalancing your portfolio involves selling some investments and buying others to restore an investment portfolio that matches your target asset allocation.
Rebalancing can also diversify the portfolio, so that the portfolio isn’t too heavily concentrated in a particular stock or set of stocks.
When you rebalance your portfolio, it reduces investment risk and can smooth out volatility, but may sacrifice some investment returns.
In effect, rebalancing implements the advice to buy low and sell high.
Many investors rebalance according to a set schedule, such as quarterly or annually, or when the allocation of any asset class changes by more than 5 percentage points from the target asset allocation.
Why You Shouldn’t Rebalance
Rebalancing is a simplistic strategy that involves selling winners and buying losers.
Why would you want to sell a stock that is doing well and is likely to continue doing well? That just doesn’t make sense.
The asset allocation is based on your risk tolerance, which can change over time. Dynamic investment strategies, such as target-date funds for retirement plans and age-based or enrollment-date investment glide paths for 529 college savings plans, change the asset allocation periodically, requiring rebalancing according to a set schedule. But, dynamic strategies often shift off of a high percentage invested in stocks too quickly.
Rebalancing usually does not increase long-term investment returns. It may reduce the volatility of your investment portfolio and keeps the asset allocation in sync with your risk tolerance. If you don’t rebalance, a diversified portfolio will maintain a higher return on investment with only slightly greater volatility.
When you rebalance your portfolio, you may sell stocks that have appreciated a lot in value. When you sell these stocks, you will realize capital gains on the investments, which will yield a tax liability unless the stocks are held in a retirement account. If the stocks have been held for less than a year, the capital gains will be taxed at a higher rate.
Selling stocks and mutual funds too frequently can also increase your other costs, since there may be fees for buying and selling investments.
Rebalancing is also inconsistent with a buy-and-hold strategy.
Decisions about selling a particular stock should be based on where you think the stock will head in the future. If you’re invested in a stock that you expect to decrease in value (or even remain unchanged in value for a long time), you should sell it. If your reason for buying the stock is no longer valid, you should sell it. But, you shouldn’t sell a stock without a good reason for selling it. Don’t sell a stock just because the stock is increasing in value.
S&P 500 Example
Most major stock market index funds and ETFs do not rebalance. They are market weighted.
For example, most S&P 500 index funds and ETFs, such as the State Street SPDR S&P 500 (SPY)
That’s why the top ten holdings of the S&P 500 index have grown to represent more than 27% of the index. The top ten holdings are Apple
There are equal-weighted index funds and ETFs for the S&P 500, where each of the 500 stocks represents the same 0.2% of the index. These funds and ETFs require periodic rebalancing. The Invesco S&P 500 Equal Weight ETF (RSP)
Equal-weighted versions of the S&P 500 have greater volatility than market-weighted versions, because small-cap stocks tend to be more volatile. The beta is 1.12, compared with 1.0 for the market-weighted version of the S&P 500.
The market-weighted S&P 500 index tends to outperform the equal-weighted S&P 500 by 2 or more percentage points per year.