You Probably Need to Rebalance

To test the weightings, I started with a simple portfolio combining 60% in equity funds and 40% in bond funds. I allocated one third of the equity weighting to foreign equity and split the domestic portion between value and growth funds. Over each period, I assumed investors took a hands-off approach and simply held the underlying assets without making any changes in the interim. In all three cases, the portfolio weightings would have drifted away from target levels, especially with respect to the mix of stocks and bonds but also when it comes to value and growth.

Five Years Since Last Rebalancing

If it's been several years since your last portfolio rebalancing, your portfolio is probably significantly out of balance.

Source: Morningstar Direct. Data as of Nov. 30, 2023

Even after the bear market in 2022, equities have still outpaced bonds by a decent margin over the trailing five-year period. As a result, my test portfolio's overall equity exposure expanded from 60% at the beginning of the period to 70.1% by the end.

That change would also have a significant impact on a portfolio's risk profile. To get things back in balance, it makes sense to reallocate assets from stocks to bonds.

Five Years Since Last Rebalancing: Overall Asset Mix (% of Total)

Source: Morningstar Direct. Data as of November 30, 2023

Because US equities outperformed their non-US counterparts for most of the five-year period, the mix between US and non-US equities is also probably ready for some adjustments. By the end of the five-year period, US stocks would have risen to 51.6% of the overall portfolio – significantly above the original level.

The mix between value and growth stocks would be significantly out of whack too, with growth stocks accounting for 30.1% of total assets, up from 20% at the beginning of the period. That means growth companies are a logical place to cut back; those assets can then be redeployed to shore up the fixed-income weighting.

Three Years Since Last Rebalancing: Fund Weightings

If it's been about three years since your last overhaul, it's probably time for some tweaks.

Source: Morningstar Direct. Data as of November 30, 2023

In this scenario, equities would have grown to about 67.4% of total assets, while bonds would be more than seven percentage points below the target level.

US equities would have drifted up to 47.7% of assets, compared with 40% in the original portfolio. The mix between growth and value won't have changed dramatically, as value stocks held up much better than growth during the 2022 bear market, but growth issues returned to the fore in 2023. Both value and growth would have been overweight compared with their target levels, making them both logical candidates to trim back and redeploy the proceeds into bond funds.

Three Years Since Last Rebalancing: Overall Asset Mix (% of Total)

One Year Since Last Rebalancing: Fund Weightings

If it's been a year since you last rebalanced, your portfolio probably doesn't need another.

Source: Morningstar Direct. Data as of Nov. 30, 2023.

Because US equities gained about 20% for the year-to-date period through November 30, 2023 (bond returns were much lower) the portfolio's overall equity exposure would have increased to about 63.3% of assets, up from 60% previously.

To keep things in balance, it makes sense to prune back equity exposure (especially from the growth side of the portfolio) and redeploy some assets back into bonds. Because US stocks have outperformed international issues by a wide margin over the past year, they would now consume about 42% of assets, up from 40% originally. Growth stocks, meanwhile, would also have drifted over the original target.

One Year Since Last Rebalancing: Overall Asset Mix (% of Total)

How to Rebalance

If you suspect it might be time to rebalance, the best way to start is to understand your portfolio's current asset mix. For Morningstar Investor subscribers, our portfolio tool can provide a quick view of the combined asset exposure for your underlying holdings. If you find certain areas have drifted away from target levels, some remodelling might help.

Conclusion

It's important to note portfolio rebalancing is mainly a tool for controlling risk – not necessarily for improving returns. Broad market trends can often persist for multiple years, meaning simply letting a portfolio's winners ride can pay off at times. For example, US-based stocks have outperformed their non-US counterparts by a wide margin over eight of the past 10 calendar years (including the first 11 months of 2023).

As a result, selling domestic winners to maintain a given weighting in international stocks has not led to better returns. That said, reversion to the mean is a powerful force, and even long-lived trends don't last forever. One of the virtues of rebalancing is to avoid getting caught flat-footed when market trends eventually reverse course.