Hey hey, and welcome back to lesson 9 of The Minimal Investor. With this course almost over, I’d love to hear from you about your thoughts on this course! If you have any thoughts at all on this course I’d love to hear it. Whether you have open questions, ideas that you connected with, topics where my writing left you confused, or anything at all, please email me your thoughts.
Lesson 8 Review – Taxes
Let’s review the last lesson (taxes) and then jump into this lesson (rebalancing). Last lesson we did a lot – I think it was the longest lesson of the entire course. Taxes are something I never thought about when I started investing. My financial advisor never mentioned them to me either. They’re just as important a topic to understand as diversification or fees!
Here’s a recap of the top points from the last lesson:
- How to calculate your tax rate. This has a huge impact on capital gains taxes.
- Capital gains taxes
- The difference between short-term and long-term capital gains.
- Paying taxes on dividends
- The difference between qualified and non-qualified dividends
- Tax-loss harvesting
- How to file taxes on investments
- Taxes when withdrawing from a 401k, IRA or Roth IRA
- Using a Roth IRA ladder if you retire with most of your funds in a 401k
Hey, I said it was a lot! Luckily this lesson and the next one will be more of a victory lap.
Lesson 9: Rebalancing Your Portfolio
If you have one mindset for the next two lessons it should be more relaxed and less on your toes ready to pounce. That is the mindset that takes time in the market to develop, but it’s important. Long-term investing doesn’t need to involve constantly checking your investment balance, reading news, making trades, or doing anything that requires action.
That’s what this lesson is about: getting into that right mindset for long-term investing and understanding what maintenance looks like for an investment account.
- You Can’t Control the Market
- Rebalancing Basics
- Contribution Rebalancing
- Conversion Rebalancing
1) You Can’t Control the Market
When I first started investing, I was constantly looking for the next “right” thing to invest in. When I wasn’t it felt like I was being lazy and that my investments would suddenly fall.
While in that mindset I was under the disillusion that if my investments dropped it would be all my fault. I had stopped watching them after all – how could I do that?
Turns out it’s more than just OK to not check on them. Having a healthy balance of time spent investing is required for good mental health – at least for me. If I was constantly checking my investments, or watching financial news, then that was a time I wasn’t spending with my family, friends or doing something productive.
This can be a tough mindset to get into. You don’t have control over the market. If you’re in a diversified portfolio that helps you sleep at night, then at least you can rest assured that you’re doing as good as the market. You won’t be the biggest winner, but you won’t be the biggest loser either (diversification is seriously magic).
Over time your portfolio will shift to where it no longer fits the exact asset allocation you’re going for. Maybe stocks will grow at 8% and bonds will only 3%. After a period of time, instead of having 50% stocks, 30% international, and 20% bonds, your assets will have shifted to 55% stocks, 35% international, and only 10% bonds!
So what do you do in a situation like this? This is one of the rare times when your account will need your help with some manual intervention in the form of rebalancing.
Takeaways:
- No really, you can’t control the market.
- Invest in what will allow you sleep at night.
- Invest in what you can ignore.
2) Rebalancing Basics
Rebalancing is an exercise where you make changes to your current investments to bring them more in line with your target asset allocation.
I find out if my investments are out of proportion by updating the “Funds” tab of my investing spreadsheet once a month (usually on the 1st of the month). At that point, I can jump over to the Asset Allocation tab and see how my asset allocation is doing.
You’ll rarely (if ever) be spot on in your target vs actual allocation. The big question then is when do you rebalance? At what point are things far enough out of whack that you need to make a change? For me, I’ll start rebalancing using Contribution Rebalancing (#3 below) immediately, but not worry about Conversion Rebalancing (#4) until a fund is at least 5% off from the target allocation – and even then with some hesitancy.
The takeaway is that you don’t need to spend a lot of time getting the “perfect” asset allocation. Whatever your allocation is, there’s probably someone somewhere who is shooting for it.
Takeaways:
- Rebalancing shifts your actual asset allocation to your target allocation.
- It’s fuzzy math, and not about getting things perfect. Be OK with it being close.
3) Contribution Rebalancing
In lesson 7 we talked about having a Pay Yourself First Mindset. Making periodic contributions automatically that come out of your paycheck or account is by far the easiest way to invest without needing to think too much. It’s also why 401k’s are the most common vehicle for investing. It’s a low enough barrier to entry.
What’s great is that you can use this periodic contribution to help you rebalance your portfolio over time. For example, let’s take the scenario above:
Target Allocation: 50% stocks, 30% international and 20% bonds
Actual Allocation: 55% stocks, 35% international and 10% bonds
So this investor needs to sell some stocks and international funds then buy bonds, right? Well, that’s one option (which I call conversion rebalancing, and we’ll go into in #4).
The other option is to invest all NEW money into bonds. This won’t balance out the account immediately. Instead, each paycheck may start getting this investor closer and closer to their target allocation. Eventually, they may be back at their target allocation, and now need to switch their automatic investment to international for a while.
This is the technique I used most often to rebalance during my earning years. Having your asset allocation be off by a few percentage points isn’t an emergency – at least if you’re investing in diversified index funds. Instead, you can get back to normal by just changing your future contributions.
I love this technique for rebalancing because it doesn’t require selling anything (which can bring up some scary taxes if you’re investing in a brokerage account).
If you’re investing entirely in a tax-advantaged account then contribution rebalancing may not have as much impact. Even for a 401k, it can be a great way to set up your account, then you won’t need to not worry about for months and months.
There is one situation where this doesn’t work as well – when you have a LOT of money. If you have $1 million invested you’d have to put away $10,000 just to shift the balance 1%. You may be able to make small changes, but the more you have, the more likely you’ll need to use Conversion Rebalancing (#4).
Takeaways:
- Use Contribution Rebalancing with automatic investments to slowly move your allocation to your target allocation.
- Check things every once in a while (quarterly or yearly) to see if you need to change what new money is investing in.
- Contribution rebalancing is most useful if you have taxable accounts where you’d need to pay taxes if you rebalanced.
4) Conversion Rebalancing
When people say “rebalancing” they tend to mean this:
I’m going to sell some of fund X and buy some of fund Y so that my asset allocation more closely matches my target allocation.
It’s the fastest and most straightforward way to rebalance a portfolio. If you’re investing in a tax-advantaged account (401k, Roth IRA, IRA), you could do this every month if you really wanted to and not pay any taxes.
I think when you’re getting started, and you’re a little antsy about the lack of control you have, rebalancing in a tax-advantaged account can be a great way to learn how to buy and sell funds. Doing this is a risk-free way of learning more about how to buy and sell funds.
The process is probably just as you’d expect it to be. Most tax-advantaged accounts allow for a conversion of funds from one fund to another without the need to sell it to cash and then move it back to the new fund. This works great for mutual funds, but won’t be an option for stocks or ETFs most places. Take a look at our same example with numbers attached:
Target Allocation: $50k US, $30k international and $20k bonds
Actual Allocation: $55k US, $35k international and $10k bonds
For this investor, they could sell $5k in stocks and $5k in international and invest $10k in bonds. That math and the process is super-simple, but hopefully, by now you may have a few alarms in your head that are going off with some edge cases. Here are a few reasons why this transaction could end up being more complicated than that.
Are capital gains taxes due?
If the stocks and international are in a taxable brokerage account, then you might be on the hook for some capital gains at the end of the year. If this was entirely short-term capital gains you may end up paying 24% in taxes – $2,400 out of the $10,000! If that was the case, you’d need to sell even more to rebalance.
Where are the funds?
Are the stocks in a brokerage and the bonds in a tax-deferred account? If so, buying bonds in that account may result in paying more taxes later. Maybe invest in a tax-exempt bond fund in the brokerage account.
Have you recently sold a mutual fund?
If you have recently sold any mutual fund, your brokerage might have a warning saying “you cannot rebuy this fund for 30 days” (Vanguard will let you know). This is because of the wash-sale rule we talked about in lesson 8 for taxes – something that lowers the likelihood of just selling then rebuying.
Takeaways:
- Conversion Rebalancing is super-straightforward but watch for hidden taxes.
Lesson 9 In Review
Keeping up with investing month after month and year after year is a hike. Don’t make it into a sprint where you focus all your attention on it, get burned out and give up. If you can set up a few systems – like contribution rebalancing using automatically investing – you’ll be in great shape to let your investments coast. You can jump in when you need and let them grow on their own the rest of the time.
Next Lesson
This is my favorite lesson of all. This is all about writing your rules for investing. You create a system that will help you succeed long-term with investing by tailoring it to your goals and risk tolerance. I’ll share my rules for investing and go over a few other ideas that might help shape your own.