Automatic rebalancing is a feature many robo-advisors have today that is designed to keep your portfolio as close to your target allocation as possible. If you invest in several types of securities at once, some will naturally outperform others.
Automatic rebalancing brings your asset allocation back in line with the targets you specify. That means you won't have to spend hours maintaining your portfolio every month.
How Does Automatic Rebalancing Rebalancing Work?
When you have a portfolio of stocks and/or bonds, you usually have certain percentages you want each to take up.
To give a simple example, let's say you have a simple portfolio of 80 percent stocks and 20 percent bonds. You own a total stock market index fund and a total stock market bond fund to achieve that.
Suppose that one year, there is a bull market and, thus, your stocks outperformed your bonds. After just one quarter, your portfolio is now 90 percent stocks and 10 percent bonds. But you don't want your portfolio to be that heavy on stocks, so it needs to be adjusted. Typically, there are two ways to accomplish this.
Cash Flow Rebalancing
Oftentimes, the best way to rebalance your portfolio is with cash flow rebalancing. With this method, instead of selling securities you already own, your portfolio is rebalanced using new cash flow.
In other words, going back to our example, any new deposits you make will go toward bonds instead of stocks. It will continue to do this until your bonds match your target allocation. Many robo-advisors and other investments platforms can do this automatically if you have automatic deposits.
This method of rebalancing is ideal because cash flow rebalancing allows you to avoid capital gains. Because you are only rebalancing with new money, you won't be selling anything you already own.
Buy/sell rebalancing means you are selling some securities in your portfolio and using the funds to buy others. Thus, our example would have you selling some stocks and using that money to buy bonds until you reach your 80/20 target.
As mentioned earlier, this form of rebalancing is generally not as good as cash flow rebalancing because it may involve capital gains. If you are dealing with a retirement account, for example, this isn't an issue because you don't pay capital gains on retirement accounts.
On a taxable account, though, capital gains are an issue. This form of rebalancing should be avoided if possible in a taxable account, especially if you have a large portfolio.
However, some robo-advisors, such as Betterment do what they can to lessen capital gains. For instance, long-term capital gains (capital gains on investments held longer than a year) is a lower rate than short-term capital gains. Therefore, Betterment defers buy/sell rebalancing until it enters the long-term territory. Then, it only does so if buy/sell rebalancing is still necessary.
Portfolio drift is what some robo-advisors, such as Betterment use to determine whether rebalancing is necessary. The way portfolio drift varies and can be a bit complicated. In general though, a formula determines drift.
For example, Betterment determines drift by dividing absolute deviation by two. "Absolute" deviation simply means it ignores negative values; for example, both 5% and -5% would be 5% absolute deviation. In that case, the drift would be 2.5%.
Betterment performs cash flow rebalancing when drift reaches two percent and buy/sell rebalancing when drift is three percent.
Why is Rebalancing Needed?
The reason rebalancing is needed is to balance your portfolio with either your investment goals or your risk tolerance. If your more volatile/risky assets perform well, they could end up occupying an outsized portion of your portfolio, increasing its volatility as whole. In this case, rebalancing brings it back into balance so it doesn't become too volatile.
In another scenario, imagine there is a bear market and bonds are increasing in value. As a result, bonds could end up taking up more of your portfolio. That might seem like a good thing during a bear market, but those bonds can be a drag on your portfolio when there is a bull market.
As you can see, the benefit of rebalancing is the bring your portfolio back into balance. That helps ensure its long-term performance to help meet your investment goals.
Rebalancing your portfolio periodically is an important part of ensuring your portfolio meets your goals and performs well in the long run. In the past, the recommendation would be to rebalance at least once every quarter. Some would suggest rebalancing every month.
However, many of us are busy and don't have the time to rebalance quite so often. Others simply aren't quite so knowledgable about investing and may not be quite so certain of the best way to rebalance.
Thus, some robo-advisors, such as M1 Finance rebalance automatically in one of two ways. They either distribute cash you deposit in a way that brings your portfolio back in balance. Or, if you choose, you can rebalance with a single click by selling some of your investments. If you do that, though, just be aware of capital gains implications.
Whatever you decide, be sure you keep your portfolio in balance to keep it performing its best. If you want to do so the easy way, create an account on M1 Finance to keep your portfolio running smoothly.