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As of June 4, 2021, the S&P 500 Stock Index is just a few points shy of its all time high.  Over the past 12 months, it is up over 40%.  With the significant increase in the stock market, should you rebalance your investment portfolio?  Maybe a better question is how often should you rebalance?

The starting point in your decision goes back to when you established your long-term asset allocation strategy in your Investment Policy Statement (IPS), which considers not only your target long term rate of return, but the level of risk that you find acceptable.  The IPS would have established your target allocation, the acceptable range within which your allocation may vary, and when the portfolio is to be rebalanced.  

For example, let us say your target allocation in your IPS is 60% to stocks, with a range of 55-65%, and 40% to bonds, with a range of 35-45%.  If today the actual allocation of your portfolio is 66% stocks and 34% bonds, you would then rebalance your portfolio to bring the allocation back to the 60/40 target and within the risk tolerance you initially found acceptable when setting the target allocation and allocation range.

Your IPS may state to rebalance your portfolio any time the allocation is out of range from its target allocation.  It may state the rebalancing is to be considered on a set time-period, such as quarterly, semi-annually, or annually and if at that time the allocation is out of range for the target, then the portfolio would be rebalanced.  If not, then no rebalancing occurs.

Your IPS may not state a range to trigger a rebalance, but to rebalance back to the target allocation on a quarterly, semi-annually, or annually basis.  This may sound like the rebalancing plan above, but the difference is that if no range is stated in the IPS, the portfolio will be rebalanced at those times no matter what the allocation may be at that time.  This may be done to minimize trading costs or taxes, especially for the semi-annual or annual time periods.

Speaking of taxes, the decision to rebalance your portfolio may also consider the income tax consequences.  Of course, this would not apply to tax deferred portfolios like 401(k) plans or Traditional IRAs, or tax-free accounts such as Roth IRAs and Health Savings Accounts.  This would apply to taxable portfolios.  This matters most depending on if you realize a net loss or realize a short or long- term capital gain.

If you end up with a net realized loss, you would be able to deduct up to a $3,000 net capital loss which would reduce your adjusted gross income and reduce your income tax liability for the year.  If you realize more than a $3,000 net capital loss, you can carryforward the excess loss into future tax years.

If you end up with a net realized short term capital gain, you pay tax at your ordinary income tax rate.  However, if you end up with a net realized long-term capital gain, the capital gains tax rate would be 0% if your taxable income in 2021 is $40,400 or less filing single, or $80,800 or less filing married jointly.  If your taxable income is over those amounts, the tax on the realized long-term capital gains would be at 15% which would be lower than your ordinary income tax rate.

So, when rebalancing your taxable portfolio, you should consider the income tax implications of your rebalancing decision and adjust the timing of your rebalancing activities, especially when you are rebalancing near the end of a calendar year and may delay some trades into the following calendar year to maximize the tax benefits in the current calendar year.

However, it is important to understand that you should not make portfolio rebalancing decisions solely on the resulting income tax consequences.  It may make more sense to pay a little more in taxes rather than having a higher level of risk in your portfolio by not rebalancing.

It is important to establish in your IPS the details of when you want to rebalance your portfolio, whatever that may be.  Rebalancing helps you to keep your portfolio on track to achieve the long-term rate of return you are targeting and the level of risk you are willing to accept to achieve that goal.