Asset allocation targets and rebalancing

Your asset allocation is the mix of investments you hold: how much in stocks, bonds and cash, and within stocks, how much in the US and abroad. It drives most of your portfolio's ups and downs.

A target allocation is the mix you've decided to hold. Markets move you away from it. Rebalancing moves you back.

Choosing a target

There's no correct mix. A target is a trade-off between growth and how far your portfolio can fall in a bad year. A few questions help:

• When will you spend the money? Money you'll spend in the next few years has less time to recover from a fall.
• How much guaranteed income do you have? A large pension or Social Security benefit covers essentials, which can let the rest of the portfolio take more risk.
• How would you react to a large drop? A mix you abandon in a downturn does more harm than a cautious one you keep.
• What does your plan need? Testing a few mixes on your own plan shows how much each changes your chance of success and your range of outcomes.

The app's default plan starts with 48% US stocks, 12% international stocks and 40% bonds. That's a placeholder, not a recommendation.

Why rebalance

Suppose your target is 60% stocks. After a few strong years, stocks have grown to 70% of your portfolio. Your risk has quietly increased. A 30% fall in stocks would now cost you 21% of your portfolio instead of 18%.

Rebalancing sells some of what has grown and buys what has lagged. It keeps your risk where you chose to put it. It isn't a way to raise returns. In long rising markets, a portfolio that never rebalances often ends with more, and more risk.

Bands: when to rebalance

Rebalancing on a fixed date, such as every January, is simple. Rebalancing only when your mix drifts outside a band around the target trades less and responds to big moves faster.

A common band is the smaller of two limits:

• a fixed number of percentage points, such as 5 points either side of the target, or
• a share of the target itself, such as 25% of it.

For a 60% stock target, 5 points gives a band of 55% to 65%. 25% of 60 is 15 points, so the 5-point limit applies. For a 4% gold target, 5 points would be far too loose. A quarter of 4% is 1 point, so the band is 3% to 5%.

The app uses this rule by default, with 5 points or 25%, whichever is smaller. You can change it for each target.

A worked example

Eli and June have $1,000,000 invested. Their target is 60% stocks and 40% bonds. After a strong year, here's what they hold:

Stocks are 68% of the total. That's outside their 55% to 65% band, so it's time to rebalance. To get back to 60%, they need to move $80,000 from stocks to bonds.

Where they make the move matters:

• Selling stocks in the taxable account would realize a capital gain. If the stocks there have a cost basis of half their value, selling $80,000 creates a $40,000 gain.
• Exchanging inside the traditional IRA creates no tax at all. They sell $80,000 of stock funds in the IRA and buy $80,000 of bond funds in the same account.

The IRA exchange gets them back to target with no tax. That's why the order of moves matters as much as the size.

Tax-aware rebalancing, step by step

1. Use new money first. Direct new savings or dividends to the parts of your mix that are below target.
2. Use withdrawals. If you're taking money out, sell from the parts above target.
3. Exchange inside tax-advantaged accounts. Trades inside IRAs, 401(k)s, Roth accounts and HSAs don't create taxable gains.
4. Sell in taxable accounts last. If you must, sell the holdings with the smallest gain per dollar first, or sell at a loss if you have one.

The app's rebalancing moves follow this order and use your cost basis where it knows it. The moves are information, not trade instructions.

Asset location

Allocation is what you hold. Location is which account holds it. Because accounts are taxed differently, where you put each asset can change your after-tax return:

• Bonds pay interest taxed as ordinary income. They often fit well in traditional accounts.
• Stocks you'll hold a long time are taxed lightly in a taxable account, and gain a step-up in basis at death.
• Assets you expect to grow most benefit most from a Roth account or HSA, where growth is never taxed.

Treat your accounts as one portfolio. A 60/40 target can hold 60/40 in total even if no single account does. The Asset location tab in the app shows where each part of your mix sits.

Funds that hide their mix

A target-date fund or a global stock fund holds several asset classes inside one ticker. To compare your holdings with a target, you need to look through the fund to what it holds.

The app does this for common index and target-date funds, using the providers' published breakdowns. It splits each one into US stocks, international developed stocks, emerging-market stocks, US and international bonds, cash, real estate and other. Holdings it can't classify are listed so you can classify them yourself, instead of being guessed. See how the look-through works.

Frequently asked questions

How often should I check my allocation?

Quarterly is plenty for most households. With bands, most checks lead to no trades.

Should my allocation change as I age?

Many people hold less in stocks around retirement to reduce sequence-of-returns risk, then hold steady or raise it later. See sequence-of-returns risk. You can test a glide path in the plan's market assumptions.

Can I target a specific fund?

Yes. In the app, a target can include a sleeve for specific tickers, such as a small-cap value fund, alongside broad asset classes.