As we reflect on the robust equity returns of the past three years, it is easy to succumb to the assumption that the current momentum is a permanent fixture of the market. However, a disciplined investment process demands that we look past the immediate rearview mirror. Significant market outperformance often leads to a natural drift in asset allocation, leaving many investors unintentionally overweight in equities and more exposed to volatility than their risk profiles allow or that their financial plan requires. With the new year upon us, now is the time to reaffirm the importance of rebalancing, the systematic process of selling high-flying assets to reinvest in underperforming areas, to ensure your portfolio remains anchored to its long-term objectives.
The primary virtue of rebalancing is its ability to mitigate risk by controlling for style drift. When certain asset classes dominate for an extended period, it can transform a balanced portfolio into an aggressive one if no one is paying attention. By trimming gains in equities that have done well and reallocating to bonds or other equity asset classes that haven’t done so well, we effectively enforce a “buy low, sell high” methodology. There might be regret in the short-term if the equities that were sold continue to appreciate. But this contrarian approach ensures that when market leadership inevitably shifts, your capital is not overly concentrated in the very areas most vulnerable to a correction.
While there are some who recommend rebalancing on a set schedule, we look to rebalance opportunistically because markets don’t adhere to a set schedule. This means we check every day to see if any asset or sub-asset classes are outside of rebalancing bands. However, we only trade when something is outside of set +/-20% tolerances. Managing portfolios in this way seeks to improve the risk-return profile.
The unavoidable trade-off of realizing gains when rebalancing is that investors will have to pay taxes on gains generated in taxable accounts. We aim to only realize long-term gains, which are subjected to your lowest tax rate. While we will always look to harvest losses aggressively to offset gains for clients, we know that taxes cannot be avoided fully. We believe paying taxes on long-term gains is a small price to pay for transitioning out of potentially overvalued asset classes and into relatively more attractive ones. The success of your financial plan depends on rebalancing.
Ultimately, we must acknowledge that the future remains inherently uncertain, and no one possesses a crystal ball to predict next year’s top performing asset classes. The tendency to believe that what happened yesterday will happen tomorrow (known as recency bias) is the greatest enemy of the long-term investor. Because we cannot know which asset class will lead the next cycle, maintaining a diversified stance is our only true defense. Rebalancing is not about chasing the next hot trend; it is about maintaining a resilient foundation that can weather any market environment.
RTD Financial Advisors, Inc (“RTD”) is a SEC registered investment adviser. Information presented is for educational purposes only intended for a broad audience. The information does not intend to make an offer or solicitation for the sale or purchase of any specific securities, investments, or investment strategies. Investments involve risk and are not guaranteed. RTD has reasonable belief that this marketing does not include any false or material misleading statements or omissions of facts regarding services, investment, or client experience. RTD has reasonable belief that the content as a whole will not cause an untrue or misleading implication regarding the adviser’s services, investments, or client experiences. RTD has presented information in a fair and balanced manner. RTD is not giving tax, legal or accounting advice, consult a professional tax or legal representative if needed. Rebalancing can help manage portfolio risk, but there is no guarantee of profit or protection against loss in declining markets. This discussion is not intended as tax advice. Consult a professional tax advisor for guidance tailored to your specific situation” would be a safer way to frame this.