Understanding Automatic Rebalancing: What, Why, & How?

Imagine an investor who has the good fortune to hold some stocks that have soared in value. Or maybe the opposite has happened, and the shares have plunged. In either case, the investor now has the same problem: The balance of assets in their portfolio has strayed from their targeted mix. The financial industry has a solution to this: automatic rebalancing.

What is automatic rebalancing?

Automatic rebalancing is the process of restoring the ratio of stocks, bonds and other assets when gains or losses move them out of alignment with the original portfolio design. Until recently, rebalancing was done manually by investors, usually based on the recommendations of a financial advisor.

Now there are algorithm-based software programs to automatically rebalance investment portfolios in online brokerage accounts with little effort. Such a feature is a standard offering in many robo-advisors, the computer-driven investment-management services that have been growing in popularity in recent years.  

Here’s an example of how rebalancing works: Consider a 40-year-old investor who specified a mix of 60% stocks and 40% bonds in their 401(k) retirement account—a blend traditionally used to optimize returns while limiting risk. Those percentages are known as an asset allocation. If stocks rally and bonds decline, the ratio may change to 70% stocks and 30% bonds. The good news is that the gains for the stocks more than made up for the loss on the bonds. The bad news is that the portfolio carries more risk now because stocks are more volatile than bonds. 

With rebalancing, the investor would sell some stocks and buy some bonds to restore the original 60-40 ratio. Some investors do this on their own. Others seek the help of a financial advisor to do the rebalancing on behalf of the investor.  A money-management firm might use an algorithm to help make the changes on a fixed schedule. Rebalancing often is done at a set time, such as once a year. Other services, such as robo-advisors, rebalance anytime the portfolio mix deviates too much from the target asset mix.

Why is rebalancing necessary?

Rebalancing is necessary to bring a portfolio back in line with the original investment plan, maintaining diversification that balances the investor’s need for capital appreciation against their risk tolerance.

In the above example, failure to rebalance would mean an investor’s portfolio takes on more risk. But the opposite is true for a portfolio with large losses in stocks.

Imagine another investor, who at age 30 has a portfolio with a more aggressive mix of 70% stocks and 30% bonds. If the equity market takes a dive, the portfolio will suddenly lean more heavily toward bonds, even though the investor is relatively young and has time to recoup the loss. If an investor does nothing, it would leave the portfolio vulnerable to underperformance when the market recovers, hurting long-term goals. Automating the rebalancing puts the process of buying stocks and selling bonds on autopilot, resetting the asset allocations to the original allocation.

How does rebalancing work?

There are several methods for rebalancing. First, there’s manual rebalancing. Investors can buy or sell securities as needed, or choose funds that have managers do the rebalancing for them. Target-date mutual fund rebalancing, for instance, changes the asset mix toward bonds and away from stocks as retirement age approaches.

Then, there’s automatic rebalancing that does the same thing with software. Automated rebalancing by a robo-advisor alone, is often the least costly, most efficient approach because it’s driven entirely by a computer algorithm. Using software, an investor enters percentages for each holding and the frequency with which they want to auto-rebalance according to their investing schedule. Unlike target-date mutual funds, the targets can be set quarterly, semi-annually, annually, or simply whenever the asset mix drifts outside a specified metric, normally about 3%.

While some robo-advisors are entirely automated, others offer human assistance in the form of investment managers who help with bad data for unknown securities, file transfer issues, and processing problems.

Automatic rebalancing by algorithm usually carries a small, fixed fee that advisors charge for choosing investments and other services, but some are free. Depending on the robo-advisor, investors pay anywhere from 0% to around 0.50% of assets per year based on your portfolio balance, with automatic rebalancing included in the bundle of services provided. Traditional investment advisors often charge about 1% of the assets under management, and may charge trading commissions when buying and selling securities during rebalancing. Investors who do their own rebalancing may also have to pay trading commissions, although some online brokers have slashed those fees, and in some cases they offer trading at no charge.

No matter how the automatic rebalancing is performed, the process requires little input or effort, making it appealing to less experienced investors or those looking to save time with a more hands-off approach.

DIY rebalancing

Rebalancing a portfolio without the help of an advisor or robo-advisor can be done without spending money upfront, but there are risks.

Let’s say an investor wants to rebalance a portfolio with one exchange-traded fund (ETF) that holds only stocks, and one that holds only bonds. This type of ETF rebalance can be done quickly and easily. Some brokerages offer no-transaction-fee trades for mutual funds and ETFs. But if an investor has a portfolio of individual stocks and a basket of bonds, the task can become complicated and costly, because they must sell individual securities and buy others to replace them. And, in a taxable account, an investor might incur capital gain taxes, with high short-term rates and long-term rates to consider.

Also, investors who manually attempt to rebalance are at risk of making emotional decisions that interfere with long-term goals. When the stock market quickly falls, the impulse may be to sell to save money, when holding on would be the better option. An automated approach is more disciplined in comparison, and avoids emotional decision-making in the buying and selling process.

Most of all, investors who choose to rebalance on their own may lack discipline and disregard the process altogether, making their asset allocations consistently out of balance.

How does automatic rebalancing impact a retirement fund like a 401(k)?

Tax-deferred retirement accounts

such as a 401(k) plan or individual retirement account (IRA) are well-suited to an automated approach because investors pay no tax on capital gains in such accounts, until the money is withdrawn. Note that investors can’t count losses against their future taxes on withdrawals from 401ks and IRAs.

Potential benefits and risks of automatic rebalancing

Although there are any number of benefits to automated rebalancing, there are some drawbacks. 

Potential benefits of automatic rebalancing

• Takes emotion out of investing

• Mitigates risk

• Portfolios remain on track with original investment targets

• Requires almost no investment knowledge 

• Minimal costs and fees

• Hands-off approach with very small time commitment 

Risks of automatic rebalancing

• Using a software alone means there’s no direct help from a real person

• Direct help may involve a fee

• Limited control of where your funds are invested

The bottom line

Markets inevitably move up and down, which can throw an investor’s preferred mix of stocks, bonds and other assets out of alignment with a portfolio design. Doing nothing to correct this can undermine an investor’s long-term strategy and goals. Rebalancing is used to restore a portfolio’s targeted blend of assets, based on an investor’s need for returns and tolerance for risk. Setting up automatic rebalancing puts the process on autopilot, requiring little or no input from the investor. This can be appealing to novice investors as well as those with more experience who prefer not to spend their time doing the intensive work themselves.