How to Rebalance Your Portfolio Before 2025

Key Takeaways

• The main advantage to rebalancing—which means pulling back on securities that have performed really well, putting the money toward things that haven’t performed as well—is risk reduction.
• Concentrate your rebalancing efforts first and foremost on those tax-deferred accounts where you will not owe a tax bill to make these changes in your portfolio.
• For retirees who have started to take their required minimum distributions from those tax-deferred accounts, they can use rebalancing to meet those distributions.
• For people with taxable accounts who need to rebalance, if they are still adding to those accounts, they can add new money to asset classes that have maybe shriveled as a percentage of the portfolio instead of selling.
• One of the most urgent types of rebalancing for some investors really involves scaling back and reducing their equity exposure in favor of bonds and cash.
• For investors nearing retirement that have neglected bonds to date should consider bonds that are high-quality fixed-income types and cash investments. For those really close to retirement, they should consider adding Treasury Inflation-Protected Securities.
• Many investors should be looking at how their stock allocations are split between US stocks and stocks from non-US markets.
• Investors should examine their portfolio’s style box positioning and maybe consider righting some imbalances through rebalancing there.

Susan Dziubinski: Hi, I’m Susan Dziubinski with Morningstar. Many investors make portfolio adjustments, including rebalancing, as the year winds down. Joining me to discuss how to rebalance as we head into 2025 is Christine Benz. Christine is Morningstar’s director of personal finance and retirement planning, host of The Long View podcast, and author of the bestselling book, How to Retire: 20 Lessons for a Happy, Successful, and Wealthy Retirement.

I’ve read Christine’s new book, and it’d be a great stocking stuffer for anyone who’d like to retire someday or for someone who already has.

Again, congratulations on the book, Christine. It’s nice to see you.

Christine Benz: I love the sales pitch, Susan. Thank you for that.

Does Rebalancing Really Pay Off?

Dziubinski: We’re here to talk about rebalancing today. First, let’s start at the beginning. Why rebalancing? Is it something that’s actually going to help improve your returns over time?

Benz: No, not necessarily. There’s been a lot of research on this topic, Susan, and the main advantage to rebalancing—which means pulling back on securities that have performed really well, putting the money toward things that haven’t performed as well—the main advantage comes in the realm of risk reduction. And the reason is pretty intuitive, that if you have highly appreciated positions in your portfolio, those are often the highest valued. They have the highest valuations. And if you have things that haven’t performed as well, their valuations probably aren’t as great. So the advantage is kind of, in a tactical-light sort of approach that you are putting money toward those securities that potentially have more upside potential and you’re reducing risk by skinnying down the positions that potentially are due for potentially some sort of fallback at some point in time.

Why Tax-Sheltered Accounts Are the Best for Rebalancing

Dziubinski: Now, Christine, you think that the approach to rebalancing that someone takes depends on a couple of key variables, starting with account type. Why is that an important consideration, and which account types lend themselves more to rebalancing than others?

Benz: Yeah, I think this is such a crucial point, Susan, that rebalancing can make sense, but it’s not a free lunch unless you can avoid the taxes. Because the idea here is you’re selling appreciated securities. If you hold them in a taxable account, well, you’re going to pay capital gains taxes at least on those gains. So the best place to do rebalancing is in the confines of a tax-sheltered account where you can buy and sell all day long, and I wouldn’t recommend that, but you can do that, and you will not trigger a tax bill as long as the funds stay within that account. So concentrate your rebalancing efforts first and foremost on those tax-deferred accounts where you will not owe a tax bill to make these changes in your portfolio.

How Rebalancing Can Help Retirees Meet Their RMDs

Dziubinski: Now, for retirees who have started to take their required minimum distributions from those tax-deferred accounts, you think there’s an elegant use of rebalancing that can help investors meet those distributions. Talk a little bit about that.

Benz: I think this has been underdiscussed in the context of retirement planning—that ideally every year you would take a step back and look at how your portfolio has performed and pull your withdrawals, and if you’re on the hook for required minimum distributions, you’ve got to take the money out of those traditional tax-deferred accounts, but you’d pull those withdrawals from the accounts that you wanted to reduce anyway. So if your US large-growth holdings, for example, are consuming an outsize share of your portfolio—and if you haven’t made any changes recently, they probably are—you would pull your distributions from those accounts. You’d fill up your cash bucket for the year ahead, and you would effectively live off of those appreciated holdings. And the same holds true if you have tax-deferred accounts and you’re subject to RMDs and you want to do a little bit of portfolio cleanup. Maybe you have holdings that you don’t love for whatever reason—those are great candidates for selling as well. So you’ve improved your portfolio, you’ve teed up your liquid reserves for the year ahead, and you’ve met your obligations to the IRS.

How to Rebalance Taxable Accounts

Dziubinski: Now what about investors who have taxable accounts and those taxable accounts do need rebalancing? What are their options?

Benz: Well, today—you know, a couple of years ago I would have said look for tax losses in your portfolio—most investors probably don’t have big tax-loss candidates, maybe individual stock investors. So you might have offsetting losses if you’re doing some selling of appreciated securities that have gained, you may be able to find offsetting losses, but a better strategy—probably more realistic for most people with taxable accounts—is if you are still adding to those accounts, you put the new money toward the asset classes, asset types that you want to add to. And so you’re not selling anything; you’re rather using new dollars to plump up the asset classes that have maybe shriveled as a percentage of the portfolio.

Why Preretirees Need to Scale Back on Equity Exposure When Rebalancing

Dziubinski: Now, you say that one of the most urgent types of rebalancing for some investors really involves scaling back and reducing their equity exposure in favor of bonds and cash. So, who should consider doing that, and what’s the benefit?

Benz: I would say for people who are within five to 10 years of retirement, taking a close look at that asset-class exposure. And I will say, Susan, it’s a very tough sell to get people at this life stage to pry their hands off of their equity portfolios, especially their US equity portfolios. But the basic idea is that if you are derisking a percentage of your portfolio, yes, you are steering some money into probably lower-returning asset types like cash, like bonds, but the beauty of having that bulwark of safer assets is that if stocks go down and stay down for a period of time, and we don’t know what the catalyst would be for that sort of market activity, but if that happens and you’re about to retire, you would have those safe assets that you could spend from. You could leave your stocks alone, let them recover. It may take a while, so I would typically recommend anything from like five to 10 years’ worth of safer assets. But that’s the basic idea: that you are not necessarily improving your portfolios’ return potential, but you are reducing your susceptibility to what retirement researchers call sequence risk, which is basically a fancy way of saying that a bad market shows up in the years right before you’re ready to retire or right after you’ve retired.

Which Types of Bond Investments Are Best for People Nearing Retirement?

Dziubinski: Let’s say I’m one of those investors, maybe, who’s neglected bonds to date, but maybe I’m getting kind of close to retirement. What types of bonds should I be considering?

Benz: It’s a good question, Susan. And I would say just keep it simple. My bias is toward pretty plain-vanilla, high-quality fixed-income types and cash investments. And the reason I say high quality is when we look at the asset classes that do the best job of exhibiting a different performance pattern than stocks, high-quality bonds do the job. So I’d focus on high-quality short- and intermediate-term, probably bond funds rather than monkeying around with a lot of individual positions. And then if I’m really close to retirement, I would also add a component of what are called Treasury Inflation-Protected Securities. So I’m augmenting that plain-vanilla nominal bond portfolio with a component of Treasury Inflation-Protected Securities. And then I’d call it a day.

Consider Your Stock Allocation Between US Stocks and Non-US Markets

Dziubinski: Now, you also think that many investors should be looking how their stock allocations are split between US stocks and stocks from non-US markets. What’s the thought behind this, given how much and for how long international stocks have lagged US market?

Benz: I was looking actually at the return of the US market over the past 10 years. It’s like 12%-plus. Non-US is like 4%-plus. So a huge gulf, but arguably a huge valuation discrepancy when you look at the valuations of non-US relative to US. Non-US also has higher dividend yields than the US market. So those are a couple of the fundamental reasons to consider adding to non-US relative to US. The other thing is just the market composition. I was also looking at this this morning: The sector composition of the US market relative to non-US is really quite different. So in the US today, I think roughly 45% of the sector exposure is coming through technology and healthcare. In the non-US markets, having a much bigger component of financial exposure, much less in technology and healthcare. So it’s kind of an indirect play on some of the value sectors that really haven’t done particularly well over the past decade. SI think you get a lot of bang for your buck in terms of doing that rebalancing from US to non-US today. And I should say it’s not saying you will completely leave behind your US exposure. You maintain it. You take it back to whatever your target is, but just plump up that non-US exposure.

How to Find Imbalances in Your Portfolio’s Style Box Positioning

Dziubinski: And then lastly, Christine, you also think that investors should examine their portfolio’s style box positioning and maybe consider righting some imbalances through rebalancing there. So for many investors today, what might that imbalance look like by style?

Benz: We’ve had a long-running rally in US large-growth stocks. In 2024, we’ve actually had a pretty broad market rally where some of these long unloved areas have gotten in on the act. So small value’s having a great year so far. But if investors haven’t looked at this for a few years, you probably still have a pretty persistent overweight in US large-growth. That has been a very easy category to just kind of carry on with, add to, but for most investors, they’re probably overleveraged to US large growth. And so if you are doing some rebalancing within the US asset class, you might consider tipping more into small caps and into the value column of the style box.

Dziubinski: Christine, thanks for your time today. Looks like you’ve given us a great playbook for rebalancing for the new year. We appreciate it.

Benz: Thank you so much, Susan.

Dziubinski: I’m Susan Dziubinski with Morningstar. Thanks for tuning in.

Watch How to Manage Capital Gains Distributions in 2024 for more from Christine Benz.