The long bull market has left many investors with a nice problem: a lot of unrealized profits in stocks. Over the past three years alone, through August, Standard & Poor’s 500-stock index gained an average of 16.1% a year, compared with 9.5% annually over the past 15 years. The hot streak means the portion of your assets in stocks, compared with other investments, may exceed your risk tolerance. The solution is to rebalance your portfolio by selling an amount of stock necessary to bring your stock portion down to a comfortable level.
Many financial pros advise rebalancing once a year. Start by totaling up all of your stocks, bonds, cash and other securities. Include assets in retirement accounts and in taxable accounts. If you own mutual funds that hold a mix of stocks and bonds (such as target-date funds), check the most recent fund report to see the breakdown of assets. Once all assets are accounted for, calculate the percentages for each asset type. (You can also use online services such as those offered by financial advisory firms Empower and Betterment for this.)
Run the numbers. Say your calculations show you with 70% in stocks, and you want to bring that down to 60%. You’ll have to decide how best to pare the equity portion. If your assets are mostly in mutual funds held in a retirement account, such as a 401(k), it’s relatively simple to shift a portion of your stock holdings into either bond investments or cash accounts, or both. The great advantage of rebalancing in a retirement account is that you won’t trigger a tax hit. If the stock investments you want to trim are in taxable accounts, you may owe Uncle Sam a piece of your capital gains. Remember, though, that mutual funds must pay out realized gains yearly, so in a taxable account you’ve been taxed all along. That may mean your tax hit from rebalancing won’t be huge.
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Rebalancing is also useful among different types of stocks. For example, most foreign stock markets have been weak performers over the past nine years compared with U.S. shares. If you think foreign issues may be relative bargains now, shifting some money from U.S. to foreign stocks makes sense (see How to Navigate Investing in Emerging Markets). The goal of rebalancing is to lower your risk of severe loss by keeping your nest egg well diversified. “We know we’re supposed to buy low and sell high,” says Liz Ann Sonders, chief investment strategist at Charles Schwab. “Rebalancing doesn’t require you to time the market. You’re just trimming strength and buying into weakness.”