Year-end is a natural time to review your portfolio. Market movements throughout the year will have shifted your allocations, and a few minutes of attention now can keep your investment strategy on track. Here's a simple framework for the annual review.
Why Rebalancing Matters
Your target asset allocation reflects your risk tolerance and time horizon. When markets move, that allocation drifts. After a strong stock market year, you might find yourself with 80% stocks when you targeted 70%. That extra 10% represents additional risk you didn't sign up for.
Rebalancing isn't about timing the market. It's about managing risk and enforcing discipline. It forces you to sell high and buy low, harvesting gains from outperformers and adding to underperformers.
The Year-End Checklist
- Review your target allocation: Before checking what you have, confirm what you want. Has anything changed. Your timeline, risk tolerance, or financial situation?
- Calculate current allocations: Total up all accounts to see your actual stock/bond split. Don't forget to include 401(k)s, IRAs, and taxable accounts together.
- Identify meaningful drift: Small variations don't require action. Look for allocations that have drifted 5% or more from target.
- Consider tax implications: In taxable accounts, rebalancing can trigger capital gains. Use tax-advantaged accounts for most rebalancing when possible.
- Execute with new contributions: Often the easiest way to rebalance is directing new contributions to underweight areas rather than selling overweight positions.
A simple rule: Rebalance when any asset class drifts more than 5 percentage points from its target, or at least once per year, whichever comes first. This provides discipline without triggering excessive trading.
Account Location Considerations
Think about tax efficiency when deciding where to hold different investments:
Tax-advantaged accounts (401k, IRA): Hold bonds, REITs, and actively traded funds here. These generate ordinary income or short-term gains that are more expensive in taxable accounts.
Taxable accounts: Hold tax-efficient stock index funds, municipal bonds, and long-term holdings. These benefit from lower long-term capital gains rates and potential tax-loss harvesting.
Roth accounts: Consider holding your highest expected growth investments. All gains are tax-free forever, so maximize the compounding advantage.
What Not to Do
Don't over-optimize: Spending hours fine-tuning allocations by tenths of a percent isn't worth your time. Close enough is good enough.
Don't rebalance too frequently: Monthly rebalancing creates excessive trading and potential tax consequences. Annual or semi-annual is plenty.
Don't chase last year's winners: The urge to increase allocation to whatever performed best is strong but counterproductive. Stick to your plan.
Don't forget about cost basis: In taxable accounts, consider which lots to sell. Harvesting losses can offset gains elsewhere.
The Zen Take
Rebalancing is one of the few evidence-based practices that individual investors can use to improve outcomes. It reduces risk, enforces discipline, and takes advantage of mean reversion, all without requiring any market predictions.
Keep it simple. A quick annual check-in is far better than constant tinkering or complete neglect. Your future self will thank you for the few minutes of attention you give your portfolio today.