Rebalancing in, risk out.

Bull markets can be like sinus attacks except instead of mucus moving in, investors’ unwanted guest is risk. While a bull market is good news for returns and investor optimism, “riding the (bull) streak for too long or sticking with the same asset allocation can negatively impact your investments if the market drops suddenly,” says Matt Harris, head of investment strategy at HighTower. The best way to keep unwanted risk out of your portfolio is by rebalancing. Rebalancing your portfolio is often the last thing on investors’ minds when times are good, but the good news is it’s easy: all you need to do is follow these seven steps to rebalance your portfolio.

Next:Set your target. Credit

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Set your target.

The first step to putting any rebalancing strategy in place is to have a target you’re working toward, says Michelle Brownstein, vice president of private client services at Personal Capital in San Francisco. If you don’t have a target allocation, you can’t know if you need to rebalance. So start by building your investment strategy with clear guidelines: What allocation of stocks to bonds do you want? How much do you want in international investments versus domestic? How much in each sector and industry? You might want to write down why you chose these allocations, so that when it comes time to rebalance, you have a reminder about why you should sell that appreciated fund.

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Rebalancing in, risk out.

Bull markets can be like sinus attacks except instead of mucus moving in, investors’ unwanted guest is risk. While a bull market is good news for returns and investor optimism, “riding the (bull) streak for too long or sticking with the same asset allocation can negatively impact your investments if the market drops suddenly,” says Matt Harris, head of investment strategy at HighTower. The best way to keep unwanted risk out of your portfolio is by rebalancing. Rebalancing your portfolio is often the last thing on investors’ minds when times are good, but the good news is it’s easy: all you need to do is follow these seven steps to rebalance your portfolio.

Set your target.

The first step to putting any rebalancing strategy in place is to have a target you’re working toward, says Michelle Brownstein, vice president of private client services at Personal Capital in San Francisco. If you don’t have a target allocation, you can’t know if you need to rebalance. So start by building your investment strategy with clear guidelines: What allocation of stocks to bonds do you want? How much do you want in international investments versus domestic? How much in each sector and industry? You might want to write down why you chose these allocations, so that when it comes time to rebalance, you have a reminder about why you should sell that appreciated fund.

Create bands around your positions.

Once you’ve set your target, you can create guidelines for yourself to determine when to rebalance. Ask yourself how much drift from your target you’re comfortable with, Brownstein says. If you’re aiming for 75% stocks, having 75.5% probably isn’t a big deal. Trying to be too finessed is likely to lead to headaches and unwanted tax consequences. A 5% shift in either direction, however, may be cause for rebalancing if you know 80% is too aggressive for you. You should place bands around your overall allocation and individual positions, she says. The more concentrated the position, the tighter the band: Individual stocks should get tighter bands than more diversified funds.

Check your portfolio regularly but not obsessively.

Your position bands will tell you when it’s time to rebalance, but to know if you’ve drifted outside your chosen threshold, you’ll need to check your portfolio regularly. This doesn’t mean checking it every day, Brownstein says. That would drive anyone nuts. “Most investors look once a week,” she says. If even that feels like too much, you can aim for monthly. At the very least she advises checking quarterly. That said, even if you only manage to check once per year, that’s better than not at all. You don’t need to rebalance every year. If your portfolio hasn’t drifted too far from your target allocation, it’s fine to leave it alone.

Be strategic about which account you rebalance in.

Before pressing the sell button, it’s important to consider the tax consequences rebalancing may have. Any time you sell an appreciated investment in a taxable account, you’ll have to pay taxes. This is why Brownstein recommends investors rebalance within tax-sheltered accounts like IRAs whenever possible. To do this, you’ll need to look at your portfolio holistically, which you should be doing anyway. If you have to rebalance in a taxable account, she says to pay attention to when you purchased appreciated shares. If you held it for one year or less, you’ll face a higher tax rate than if you sell shares you’ve held longer than one year.

Use tax-loss harvesting strategies to mitigate taxes.

Another strategy to mitigate taxes is tax-loss harvesting whereby you sell a position at a loss to offset your gains (up to $3,000 per year). You then repurchase the harvested position 30 days later (earlier than that can trigger a wash sale, which would disallow your loss). To not let your portfolio get out of balance in the meantime, Brownstein suggests replacing a harvested position with one that’s similar but not “substantially identical” by IRS standards. For example, if you harvested Netflix (ticker: NFLX) at a loss, you could replace it with an S&P 500 fund, she says. You couldn’t replace an S&P 500 fund with another S&P 500 fund, however, because these would be considered substantially identical by the IRS and cause the agency to disallow the loss.

Buy your underperformers on sale.

Once you know when and where to rebalance, the real fun can begin. This is when investors’ favorite maxim comes into play: Sell high, buy low. “When rebalancing, identify underperforming sectors of the market where you may be underweight, and reallocate to them,” Harris says. It probably won’t feel good to give up your outperformers in favor of the underperformers, but remember you haven’t actually made any gains until you sell. No matter how high your investments rise, their value remains theoretical until you trade them in for cash. The flip side of that is buying underperformers is like shopping on sale. Who doesn’t love a good deal?

Think like a robot.

“The key to rebalancing is doing it in a non-emotional way,” Brownstein says. “The biggest challenge with rebalancing is the fact that you have to sell things that have done well and buy things that have done poorly.” It’s hard to let go of a winner, especially when the market appears to be doing nothing but going up. It may help to remember that every percentage more your winners claim of your overall allocation adds another degree of risk to your portfolio. Successful investing isn’t just having the right strategy, but also having enough discipline to stick with it and not just rebalance when you feel like it, Brownstein says.

How to rebalance your portfolio in seven easy steps.

Set your target.Create bands around your positions.Check your portfolio regularly but not obsessively.Be strategic about which account you rebalance in.Use tax-loss harvesting strategies to mitigate taxes.Buy your underperformers on sale.Think like a robot.1 of 10

Coryanne Hicks, Staff Writer

Coryanne Hicks is an investing reporter for U.S. News & World Report. She is an expert at ...  Read more

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