If you’re an investor or want to be one, you’ve probably heard that it’s critical to rebalance your investment portfolio. Rebalancing is shifting investments, so you have the right balance of risk and reward to achieve your goals without sleepless nights.

This post will review what investment rebalancing is, why it’s essential for success, and six strategies to rebalance your portfolio, whether you’re a novice or an experienced investor.

What is investment diversification?

Before we discuss specific rebalancing strategies, I need to review investment diversification and how the two are related. Being a diversified investor means you reduce potential risk by owning various assets that aren’t correlated or move together when economic conditions change.

Owning investments that react differently to events like changes in interest rates or the housing market helps smooth out risk over the long term. When market conditions change, you want to own a mix of investments that aren’t all simultaneously affected by the same factors. 

For instance, if you only own a couple of domestic technology stocks, changes in the US economy or the tech industry could cause your entire portfolio to plummet. However, having a diversified portfolio helps prevent losses in a single type of investment. When you own various classes of assets, some lose value, and others hold steady or increase, which benefits your overall portfolio.

You can diversify on many levels, such as your asset classes, like stocks, bonds, real estate, and cash. With stocks, you can diversify across company sizes, such as large-capitalization, mid-cap, and small-cap stocks. 

You can be diversified with your investment industries, like energy, technology, and consumer goods, and even with geographies, like owning domestic and foreign companies. 

Let’s say you want your overall asset diversification to be 80% stocks, 15% bonds, and 5% cash. Consider what happens when your stocks go on a tear, and their prices increase. Your allocation would quickly drift, making stocks a more significant percentage of your portfolio. 

Over time, your desired 80/15/5 allocation could become 85% stocks, 10% bonds, and 5% cash. Rebalancing is a way to shift your portfolio back to the original proportions you believe are suitable for your financial goals.

RELATED: Should I invest extra money or pay down my mortgage?

What is investment portfolio rebalancing?

Investment portfolio rebalancing means getting your diversification and asset allocation, such as the mix of stocks and bonds, where you want them. Otherwise, your portfolio would continue drifting off your intended path and become increasingly risky.

For instance, having a larger proportion of stocks or stock funds could make your overall portfolio too volatile and risky for your liking. If the stock market dips, you could experience a greater loss than you’re comfortable with. 

If you decide that owning 80% stocks, 15% bonds, and 5% cash is the right balance of risk and reward, periodically rebalancing to achieve that mix, manages your risk and ensures you’re moving forward with the right investments. By the way, those percentages might be an appropriate allocation for some investors but aren’t a recommendation for everyone. 

Every investor must first define their financial goals, timeline, and risk tolerance. In general, younger investors with decades to go before they need income from their investments can lean toward riskier assets, like stocks. 

However, investors nearing or in retirement should reduce risk by owning a higher percentage of income investments, like bonds and cash. Again, you must choose investments based on your risk tolerance, and be willing to stick to that “thesis” or proactively change your allocation based on new information or developments with your finances.

How do you make money investing in stocks while limiting your risk—even when you have little experience or money? In episode 649 of Money Girl, Laura helps you learn the pros and cons of stocks and the best ways to own them to build wealth safely. Listen in the player below as you read on.

What are the pros and cons of investment portfolio rebalancing?

The primary benefit of rebalancing is maintaining your desired portfolio diversification and minimizing potential risk. By periodically reviewing your investments, you decide whether you’re comfortable with any new allocation or want to make changes, such as increasing or decreasing your stock, bond, and cash holdings. 

The downside of rebalancing is that you may need to sell investments, which can generate taxable gains inside a brokerage account. However, investment gains get deferred inside tax-advantaged retirement accounts, such as a workplace plan or IRA, so rebalancing never triggers taxes in those accounts.

6 strategies for rebalancing your investment portfolio

Now that you understand the importance of investment rebalancing, you may wonder when or how often you should do it. The goal with rebalancing isn’t perfection because your desired allocation is a moving target because investment prices constantly change. 

But here are six rebalancing strategies to consider.

1. Rebalance with another financial task.

Many investors rebalance when working on other financial tasks, like submitting their tax returns. 

2. Rebalance before the year ends.

You might prefer to review your portfolio and rebalance before the end of the year. That allows you to do tax-loss harvesting to offset any taxable gains that selling investments could trigger. 

Harvesting losses is a tax strategy where you sell losing investments to offset or reduce capital gains taxes generated by selling profitable investments. 

3. Rebalance at a threshold.

You can also rebalance when you reach a threshold, such as experiencing a 5% gain or loss in any asset class. However, you shouldn’t rebalance too frequently because you might respond too quickly to a short-term change.

4. Rebalance as you invest.

If you regularly invest, such as making monthly contributions to your workplace 401(k) or an IRA, you can review your portfolio for any over-weighted asset classes. Then, you can increase your purchases of under-weighted assets.

5. Rebalance as you make withdrawals.

If you’re retired and regularly making investment withdrawals, you can sell those that are over-weighted to bring the portfolio closer to your original allocation. You may not be able to rebalance completely in one month, but you can progress regularly. 

6. Rebalance automatically with a robo-advisor.

If rebalancing seems like a hassle, consider using a robo-advisor, like Betterment or Acorns, that does it for you automatically. They typically offer well-diversified investment options, rebalancing, tax-loss harvesting, and more features with low management fees. 

They ask you to complete a quiz to determine your goals and risk tolerance and choose various investments like exchange-traded funds (ETFs) to achieve them. However, you can manually change them at any time. Then, a robo-advisor periodically rebalances your holdings to keep your portfolio aligned with the goals you set or adjust.

READ ALSO: Maximize your investments effortlessly–8 key benefits of robo advisors

Steps to manually rebalance your investment portfolio

If you’re a do-it-yourself rebalancer, here are the basic steps you’ll need to follow. 

Step 1: Track your portfolio.

You might keep your investments on a spreadsheet or use a dashboard like Quicken or Empower. Once you list them with their current values, note the percentage for each asset class, such as stocks and bonds.

Step 2: Compare to your ideal portfolio.

Once you know your ideal portfolio, such as 80% stocks and 20% bonds, you can compare it to your current percentages. 

Step 3: Make adjustments to your portfolio.

Let’s say your portfolio drifted to 75% stocks and 25% bonds. In that case, it’s time to rebalance by investing new money in stocks or selling bonds to buy stocks so you return to the original 80/20 allocation.

Remember that selling investments in a taxable brokerage for a gain means you’ll owe capital gains tax. Rebalancing often forces you to take some profits. Plus, there may be a trading fee or commission to buy or sell certain funds and individual bonds; however, most brokerages don’t charge for transactions on stocks and ETFs. 

Suppose you become more risk-averse or tolerant. In that case, you can always adjust your allocation by manually rebalancing or adjusting your risk settings with a robo-investing platform that automatically rebalances for you.