Maintaining Appropriate Risk Level for Investor’s Goals is Key 

Key Takeaways:
  • Rebalancing your investment portfolio is essential to maintaining the desired risk level and optimizing returns over time.
  • Regular discussions with your investment advisor about your risk tolerance and asset allocation ensure your portfolio remains aligned with your financial goals.
  • Strategic rebalancing can enhance tax efficiency through practices like tax-loss harvesting and timing capital gains.

 

Investment portfolios are typically built with a diverse range of assets because they aim to achieve specific financial goals while managing risk. Some investments will be on the safe side, and others will be more aggressive. If they balance out correctly, they keep the portfolio within the range of the investor’s overall risk tolerance. 

But market fluctuations and the varying performance of different asset classes can cause the initial asset allocation to drift. This drift can expose the portfolio to unintended risks and push it out of the investor’s desired risk tolerance range.  

Additionally, risk tolerance changes over time as investors grow older and their circumstances and financial goals change. Many investors become less risk tolerant as they grow older because they have less time to recover in the event of significant investment losses.  

That’s where the magic rebalancing comes in. Rebalancing is the process of realigning the portfolio to its target allocation. Rebalancing is key to maintaining the right balance of growth and safety. 

The premise of rebalancing is that different investments grow at different rates. Also, during certain economic cycles, higher-risk investments may grow to overtake more of the portfolio than you may have intended. Those investments are trimmed back in order to get back into the target risk range. 

Rebalancing in the Background 

Generally, rebalancing takes place in the background. Your investment advisor takes care of strategic buying and selling based on discussions with you about where the portfolio is, how far its risk profile may have drifted, and what you would like to achieve in terms of a course correction. These discussions should occur at least once a year, and more frequently – even quarterly – for certain types of investments. Those would include qualified retirement accounts where there are not tax consequences to making a transaction, such as IRAs, Roth IRAs, SIMPLE IRAs and 401(k) accounts. 

For non-IRA accounts, rebalancing is typically done either annually or semi-annually. Doing it more often could result in tax consequences. 

Rebalancing is essential to maintaining the desired risk level, optimizing returns and adhering to investment strategies. 

Without rebalancing, an investor might be exposed to higher levels of volatility than they are comfortable with or capable of handling. By periodically rebalancing, investors can ensure that their portfolio remains aligned with their risk tolerance, thereby protecting themselves from unexpected market downturns and reducing the likelihood of panic selling during market turbulence. 

Optimizing Returns 

While maintaining the desired risk level is crucial, rebalancing also plays a role in optimizing returns. The concept of “buy low, sell high” is central to investing success, and rebalancing inherently encourages this practice. By selling assets that have appreciated and buying those that have underperformed, investors can capture gains and invest in undervalued assets, potentially enhancing the portfolio’s long-term returns. 

Rebalancing can also take advantage of market cycles. Markets are cyclical, and different asset classes tend to perform better in different phases of the economic cycle. For instance, during an economic expansion, equities might outperform, while bonds might do better during a recession. By rebalancing, investors can systematically shift their allocations in response to these cycles. 

Tax Efficiency 

For taxable investment accounts, rebalancing can also offer tax advantages. While selling appreciated assets can trigger capital gains taxes, strategic rebalancing can help manage these tax liabilities. Investors can offset gains by selling underperforming assets at a loss, a strategy known as tax-loss harvesting. This approach can reduce the overall tax burden and improve after-tax returns. 

Moreover, rebalancing can be timed to take advantage of lower capital gains tax rates or to defer gains until a more favorable tax year. By carefully considering the tax implications of rebalancing decisions, investors can enhance the tax efficiency of their portfolio. 

What Should Investors Do? 

If you haven’t had a discussion with your investment advisor about your risk tolerance and your asset allocation in more than one year, you’re probably overdue. 

  • Meet with your advisor to discuss such issues as retirement, changes in your family, changes in future plans and the status of your estate planning.  
  • Include such questions as whether you have any upcoming distributions or whether you may need to take money out of a retirement plan for a business investment or other expense. 
  • Ask your advisor about rebalancing. Is he or she doing it on a consistent basis, and if so, how often? If you haven’t met in more than a year, what are the rebalancing decisions based on? 
  • What is your advisor doing about tax loss harvesting? 
  • Most importantly, is there a strategy for the rebalancing that is being done, or is it based on what is being done for other investors whose priorities may be different than yours? 

Conclusion 

Rebalancing an investment portfolio is critical for maintaining the desired risk level, optimizing returns, adhering to investment strategies and managing tax-related aspects of investing.  

If you would like to discuss your risk management and priorities for rebalancing your portfolio, contact an Adams Brown Wealth Consultant. 

AdamsBrown Wealth Consultants, LLC and Private Client Services do not offer tax or legal advice. Always consult a professional regarding your specific situation.