Portfolio Rebalancing: The 5 Biggest Pitfalls and How to Avoid Them
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Welcome to the Stay Wealthy Podcast. I'm your host, Taylor Schulte, and today I'm wrapping up our mini series on portfolio rebalancing by sharing the five biggest pitfalls that you need to watch out for. In fact, making just one of these mistakes could wipe out all the benefits of rebalancing entirely.

Links and resources for this episode can be found by going to youstaywealthy.com forward slash 97. And just like last week, we are not going to waste any time today. So as a really quick recap from part one, portfolio rebalancing is the process of bringing your asset allocation back to the target percentages that you or your financial advisor have established.

Asset classes in your portfolio, the underlying investments in there, they don't all move in the same direction. At least they shouldn't if you're properly diversified and you have a well-constructed portfolio. So from time to time, you or your financial advisor will need to put the puzzle pieces of your portfolio back together again to ensure that your investments continue to match up with your retirement plan and your risk profile.

forgetting about your investments. Well, you know, it can be good from a behavioral perspective, right? Take the long-term approach, ignore the noise, don't make short-term irrational decisions. You know, forgetting about your investments can be good from that perspective, but really just absolutely neglecting your investments and not rebalancing can cause a lot of long-term problems. And in some cases could even put your retirement in jeopardy.

As a reminder, the two main benefits of rebalancing that I talked about are number one, maintaining your desired risk level and asset allocation. And number two, boosting long-term investment returns by rebalancing between asset classes that have similar risk return profiles.

For example, large cap growth stocks and international stocks rebalancing between those two asset classes with similar risk return profiles, research has shown can actually boost long-term returns.

Given that the benefits can not only ensure a successful retirement, but also boost long-term returns, it's really important to process your rebalances without making any big mistakes. And that's what I'm here to help with today. Today, I'm going to share the five biggest pitfalls that you need to watch out for and how to avoid them.

Number one, my favorite topic, taxes. So number one is ignoring taxes. Most retirement investors don't just have money in retirement accounts. They typically also have savings in what I call taxable brokerage accounts. These are either held in your individual name or in joint tenancy with your spouse or in a perfect world in the name of a living trust.

To keep it simple, I'll continue to refer to these as taxable accounts since unlike an IRA or 401 , you're required to pay taxes on dividends, interest, and capital gains in the year that they are realized. So to me, the account is taxable. When rebalancing investments in your taxable account, it's quite possible that you'll be prompted to sell something with an unrealized capital gain.

Here's an example of what an unrealized capital gain is in plain English. Let's say that you bought $10,000 of the S&P 500 ETF known as SPY. Let's say you bought $10,000 of SPY in your taxable account.

The fund has gone up in value and now your original $10,000 investment is worth $15,000. Well, in this case, you have an unrealized gain of $5,000. And if you sell some or all of your SPY fund, your S&P 500 ETF,

you're going to realize some or all of the capital gains and you'll be required to pay capital gains taxes on it this year. And we can say the same thing about other investments like real estate. If you bought a house for a million dollars and now it's worth $2 million, you have an unrealized capital gain of $1 million.

Now, of course, in real estate or primary with your primary residence, there is an exclusion that you can use to offset some of those gains. But you'll realize the gain when you sell your house and you'll be required to pay capital gains taxes on the money that you made. But for now, while you're living in your house and you're just watching the value go up for now, that's just an unrealized gain.

So back to rebalancing. Like I said, it's quite likely, especially since the stock market has done pretty well for a long period of time, it's quite likely that when you go to process a rebalance or when your financial advisor goes to process a rebalance in your taxable account, you'll be prompted to sell something with an unrealized capital gain, which will realize those gains and create a current year tax bill.

Most people fail to ever calculate their after-tax investment returns, and it kind of reminds me of our friends that enjoy gambling in Vegas. We always hear about how much money they won, but they aren't so quick to tell us how much it cost them in losses or, in this example, taxes in order to make that money.

Depending on your tax situation, $5,000 or $10,000 in long-term capital gains or even $20,000 in long-term capital gains here and there as part of your regular rebalance, it's probably not going to create any major issues.

But when rebalancing accounts, especially if you use a software or even an automated robo advisor type investing solution, it's pretty easy to overlook and just miss large tax consequences.

And as a reminder, long-term capital gains tax rates are pretty favorable and can be anywhere from 0% to 20-ish percent. However, short-term capital gains, these are investments that you've held for less than one year, are taxed at your ordinary income tax rate. So if you're still working or you're in retirement and you've got pension and social security and RMDs,

and you're in a high tax bracket, you may be looking at a giant tax bill as part of a rebalance that could just wipe out all the benefits entirely. So it's incredibly important to navigate carefully around taxes when processing a rebalance and to understand all of the tax laws associated. It's also important to know when it's okay to go ahead and pay the taxes.

As a general rule of thumb, I like to say that you shouldn't let the tax tail wag the investment dog. In other words, don't hold on to an investment that you shouldn't be holding on to just because you don't want to pay some taxes.

Like all things, it's important to have a bigger plan in place to help you make these decisions so you don't feel rushed or stressed when you're trying to decide what to do and if you should realize these taxes while you're in the middle of a rebalance during maybe a volatile market. So it's important to have a bigger plan in place to help you make these decisions.

So that's pitfall number one is ignoring taxes. Pitfall number two is trading fees. So similar to taxes, trading fees can eat away at the benefits of a portfolio rebalance. Now, I know what you might be saying right now, Taylor, I don't have trading fees. The brokerage firm that I use gives me free trades or my brokerage firm has dirt cheap trading fees that only cost me a few dollars here and there.

However, as I've noted on the podcast a number of times, there is no such thing as a free trade. We saw this on a really extreme level a few weeks ago with GameStop and the whole Reddit fiasco. But on a not so extreme level, free trades or low cost trades just mean that the brokerage firm is going to make up for that cost in other ways.

one of those ways being something called the bid ask spread. And I've discussed the bid ask spread in a number of episodes here on the podcast. I'll be sure to link to some resources if you want to dig deeper. I'll link to some resources in the show notes, which again can be found at youstaywealthy.com forward slash 97. But for now, in short, when you buy or sell a stock or an ETF,

There's another investor on the other end of every trade for every, for every buyer, there's a seller and vice versa. So your brokerage firm has to match the two of you up when you want to go make a trade. And they don't just do that for free. There's a fee in the middle for providing that service and it can be really high. It's also very well hidden. So you may never even realize that you, you paid it or you're about to pay it.

One easy way to avoid the bid-ask spread is to use mutual funds. Now, this isn't just a reason alone to go and use mutual funds, but one way to avoid it if it just kind of stresses you out and you don't want to figure it out is to use mutual funds. I talked about this during our series last September on investing and how to invest in stocks. I'll link to that episode in the show notes as well if you missed it or you want to go back and re-listen.

But in summary, we have to be very mindful of trading fees when processing a rebalance because even small fees can start to add up, which is one of the reasons why it often doesn't make sense to rebalance in an account more frequently than maybe quarterly.

The trading fees, even the bid-ask spreads behind the scenes can erode all the benefits of rebalancing if you do it too often, daily, weekly, monthly. And don't forget about taxes as well, especially short-term capital gains. If you're rebalancing daily, weekly, or monthly, you might be triggering a lot of short-term capital gains depending on the environment that we're in.

So pitfall number two, be careful, be very mindful of trading fees, understand the bid ask spread and all the other fees associated with every trade that you make. Number three, processing a fake rebounds. As discussed in the past, there are investments out there that are marketed as safe and

and they have stock-like characteristics. For example, high-yield bonds, bank loans, emerging market bonds, and yes, even the beloved tax-free municipal bonds.

These are examples of things that when things get ugly during catastrophic events, we can rewind to the COVID crash or 08, 09, when things get ugly. These are some examples of asset classes that have stock-like characteristics that start to behave like stocks during difficult time periods. And remember, the main reason for rebalancing your portfolio in the first place is to keep your desired risk level in line.

By swapping a stock-like investment for another stock-like investment, you might just be paying unnecessary fees and taxes to make a lateral change that doesn't provide you with any real benefits. And this is especially important to pay attention to right now, given that the stock market, the U.S. stock market, has been screaming upwards lately.

If your rebalance is leading you to lighten up your stock allocation because your portfolio is now way outside of your target risk, just be very careful about selling some of your stocks to go and buy asset classes that can also behave like stocks.

And this is where looking under the hood of your investments just becomes really, really critical. Don't simply trust the name of the fund or the marketing materials on the fund's website or even historical returns. It's really important to understand what exactly is inside the fund. How much risk is being taken? How much risk are they able to take in the fund?

and how the underlying holdings of that fund behave with other holdings in your investment account. So when you go to process that rebalance, make sure you understand everything in your portfolio so that you're not processing a fake rebalance. Pitfall number four, failing to take future distributions into consideration.

If you're in retirement and you're taking withdrawals from your portfolio, or maybe you just simply know that you have a large expense coming up in the next, let's say, 12 months, and you know that you're going to need to tap your investment portfolio to pay for it.

If that's you, be sure to take that into consideration when you process your next rebalance. It's extremely valuable to coordinate rebalancing with planned or known withdrawals to reduce risk in your portfolio, to free up cash for future liquidity needs, and all while navigating around taxes and mitigating the fees associated with the trades that are in conjunction with a rebalance.

So let's say that you have a million dollar portfolio that's due for a rebalance today. In six months, you know that you're going to need to take out $100,000 from your portfolio to buy that dream pool, to install that dream pool now that you're in retirement. Now that you're in retirement, you want this $100,000 dream pool. And in six months, you have to write the check to the contractor.

It likely makes sense to go ahead and carve out that $100,000 today, even though this is six months away. It likely makes sense to carve out that $100,000 today as part of your rebalance and set it aside in a high yield savings account so it's there when you need it.

You might be asking, well, why would I take money out from my investments before I need it when that money could be working for me and it could produce a nice return? Why would I take it out and put it in cash where it's going to earn pretty much close to zero and lose money to inflation every day?

To which I say, well, you know, what if COVID round two hits in six months and we see another COVID crash or something new catches the economy off guard, which happens every couple of years and your $1 million loses 10% and is now worth $900,000 at the exact time you need to write that check to the pool contractor.

In situations like these, even if an expense is three to five years away, I like to play this little what I call what's worse game with myself or even my spouse or with a client if I'm talking through this situation.

So for example, let's say that you want to buy a bigger, better house in three years from today. And you know that you're going to need $500,000 from your $1 million investment portfolio. So again, three years from now, you're going to need $500,000 from your $1 million investment portfolio.

And right now you're due for a rebalance and you're wondering, you know, should I take out that $500,000 now as part of my rebalance or should I just let it ride for three years and see what happens? So this is where I play this, this what's worse game. What's worse. You sell the $500,000 today as part of your rebalance and you set it aside in cash.

And then in three years, you figure out that had you left your money invested, your account would be worth $1.3 million. In other words, you missed out on $300,000 of investment gains because you were playing it safe and trying to be smart. And you took the money out three years in advance and you put it aside so that you knew it was going to be there.

and you're crunching the numbers and you realize, and you just missed out on $300,000 of investment gains by doing that. So that's scenario number one. What's worse here? Scenario number one or number two? Scenario number two is, let's say you decide to take the risk and you say, you know what? I'm going to process my rebalance today, but I'm just going to keep all the money invested. It's three years from now. What could possibly happen?

Or even worse, it's three years from now. I'm definitely going to make money in three years. But let's say the opposite happens. And at the end of three years, your $1 million is now worth $700,000.

and you're supposed to buy that house, that could really hurt. Now, only you can decide what's worse here. In that second scenario, you might conclude through a conversation and talking with your spouse, you might conclude that, you know what, if that were to happen, it's not that big of a deal. I'm not in a huge hurry. We love our current house. We don't have to have that next house. So if that were to happen, we would just wait for things to recover and we would put our new house on hold.

That might be how you feel. On the flip side, you might say, no, I need that money in three years. I can't, I cannot risk it. Then that might feel worse and you might choose option one. So you can play that game with yourself as you think through this. And it doesn't have to be $500,000. I play this game, whether it's, you know, $50,000 or $20,000. If you need money to buy that new car or pay off a debt or whatever it might be,

When you go to process that rebalance, you might do it in conjunction with raising that cash and getting that liquidity now so that that money is not at risk and it's there when you need it. Now, you get beyond three to five years and you get into six, seven, eight, nine, 10 years. You have longer windows to play with there. But I would argue that three years, anything could happen in three years. Anything could happen in five years.

And in reality here, let's be honest, anything could happen in 10 years. We've seen plenty of lost decades where there's 10 years of no returns or even slightly negative returns. So depending on your asset allocation and how much risk you have, that window might need to be 10 years or more. Only you can crunch those numbers or your financial advisor.

So in summary, it's important to think through your future plan distributions and liquidity needs so that you can process them in conjunction with a rebalance while you're reducing risk and mitigating fees and taxes through that rebalance.

All right, pitfall number five is failing to stick to your plan. Whenever us human beings are at the wheel, we can easily get in our own way. And it's really easy for that to happen when it comes to rebalancing. For example, if you're a

Let's say that today is the day you're supposed to process your rebounds, but the market is doing so well. You just got a bonus at work and you're feeling really good and you don't really want to reduce risk in your portfolio through this portfolio rebounds that you're supposed to do today. You think that things are going to continue to go well and you just want to keep it in the market. You don't want to process this rebounds. You decide to skip it and you're just going to wait a little bit longer. You're going to wait a week or two weeks or three weeks or just kind of feel it out.

Similar to my buying a house analogy, this can really end in one of two ways. And so you could consider playing the what's worse game here. However, I would probably argue that the what's worse game really isn't very fitting for this example because creating a rules-based systematic rebalancing plan is wildly important and critical in order to reap the long-term benefits of rebalancing. The second that you veer off track

and you try to time things or your financial advisor tries to time things and you or your advisor second guesses the system that you put in place, that's where you can get yourself into trouble. Investing is a long-term game and you have to be careful about making short-term, emotional, sometimes irrational decisions that can disrupt the benefits of being a smart long-term investor.

create a systematic rebalancing plan and stick to it through thick and thin. Remember,

The asset allocation of your investments shouldn't change unless your investment policy statement changes and your investment policy statement shouldn't change unless your financial plan changes. So the next time you get into the driver's seat and you think about turning left when you're really supposed to be turning right, ask yourself, has anything changed? Has my financial plan changed?

If not, stick to the plan, stick to the system that you put in place and get out of your own way.

For the links and resources mentioned today, head over to youstaywealthy.com forward slash 97. I hope this two-part series on portfolio rebalancing was helpful. There's a lot more that we can dive into in the future. As always, thank you for listening, and I will see you back here next week. This podcast is for informational and entertainment purposes only and should not be relied upon as a basis for investment decisions. This podcast is not engaged in rendering legal, financial, or other professional services.