Long-term investing requires a robust asset allocation strategy, which involves distributing your investments among various categories such as stocks, bonds, cash, gold, and real estate. The idea is to balance your desire for returns and risk tolerance, with several rules of thumb available. For instance, setting the stock portion at 100 minus your age (e.g., 76% stocks for a 24-year old) makes it more conservative as you get older.
Rebalancing
However, sticking to an asset allocation strategy means rebalancing your portfolio. This process of getting each category’s percentage back to the target level can be tricky for several reasons: determining how often to rebalance, procrastination, and dealing with tax implications. While annual rebalancing is widely considered ideal, it may be improved through monthly or quarterly adjustments.
Procrastination
Procrastination occurs because inertia makes this task less urgent. Also, the portfolio might appear out of balance after a year due to its increased share of winners and lesser losers. Selling your winners is emotionally challenging, while buying the laggards is even tougher.
Capital Gains
The third issue with rebalancing is taxes. Capital gains tax must be paid on sales of winners, with no offsetting losses since losers are not sold. To alleviate this problem, a simple trick can help: use your contributions to rebalance your portfolio instead of dividing them according to the target percentages.
When contributions are frequent and significant in the early phases of building your portfolio, you can do it by placing your contribution into the category furthest from its target level each month. The same approach can be employed during the withdrawal phase, selling the category with the highest dollar value above the target. However, as your portfolio grows over time, market volatility may require reversion to traditional rebalancing methods (selling winners and buying laggards).
By cleverly using contributions to rebalance your portfolio and considering tax-advantaged accounts like IRAs and 401(k)s, you can minimize the amount of capital gains taxes incurred. Do you manage your retirement funds via asset allocation? Share any tricks you employ to maintain balance in the comments section below.
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