Risk tolerance questionnaires ask things like “How would you feel if your portfolio lost 20%?” Most people answer those questions on a calm day, when nothing is falling. The answers tend to be braver than the behavior that follows when something does fall.
A better way to think about it is in dollars and in time. Then once you’ve picked a mix, a single yearly check keeps it from drifting into something you never chose.
Turning percentages into dollars
Suppose you have $100,000 invested. A portfolio of 90% stocks and 10% bonds would have to absorb a large hit in a severe bear market. If stocks fell 40%, which has happened in U.S. history, that portfolio would drop by roughly $36,000 before counting any change in bonds. A 60/40 portfolio in the same scenario would be down roughly $24,000. A 40/60 portfolio, about $16,000.
Now picture each of those numbers on your statement, maybe for a year or two, with the news telling you it could get worse. Which one would you sit through without selling? That’s closer to your real tolerance than any questionnaire score.
There are really two separate things here, and it helps to keep them apart. Risk capacity is how much loss your situation can absorb: when you need the money, how stable your income is, whether you have an emergency fund. Risk tolerance is how much loss you can stomach emotionally. Your stock allocation should respect whichever one is lower. Someone 30 years from retirement has the capacity for a lot of stock, but if they’d sell in a panic, the capacity doesn’t help them.
It also helps to keep money you’ll need within the next few years out of stocks entirely. A down payment planned for next spring belongs in savings or short-term Treasuries, not in your long-term portfolio.
Why the mix drifts
Once you pick a target, the market starts changing it. Stocks and bonds grow at different rates, so the proportions shift on their own.
Take that $100,000 portfolio at 60% stocks ($60,000) and 40% bonds ($40,000). Imagine stocks rise 20% in a year and bonds stay flat. Now you have $72,000 in stocks and $40,000 in bonds, $112,000 total. Stocks are now about 64% of the portfolio. Leave that alone for several good years and you might end up at 75% stocks without ever deciding to take on more risk.
The reverse happens too. If stocks fall 30% from $60,000, they’re worth $42,000. With bonds still at $40,000, the total is $82,000 and stocks are only about 51%. You’d be holding less stock than you planned right after prices dropped.
What rebalancing does
Rebalancing means moving money back to your targets. In the good year, you’d sell about $4,800 of stocks and buy bonds, bringing you to $67,200 in stocks and $44,800 in bonds, which is 60/40 of $112,000. In the bad year, you’d do the opposite: move about $7,200 from bonds into stocks, ending at $49,200 and $32,800.
Notice what that second trade feels like. You’re buying stocks after they just fell 30%. It’s uncomfortable, and that discomfort is the point. Rebalancing is a rule that makes you trim what has grown and add to what has shrunk, which is the opposite of what feelings usually suggest.
Rebalancing isn’t mainly a way to boost returns. Sometimes it helps, sometimes it doesn’t, depending on what markets do next. Its main job is to keep your risk at the level you chose.
A simple yearly routine
Pick one date a year. Your birthday, the first week of January, or whenever you do your taxes. On that date:
- Add up every investment account, including your 401(k), IRAs and any taxable brokerage account, and treat them as one portfolio.
- Work out what percentage is in stocks, bonds and cash.
- Compare with your target. If anything is off by more than about five percentage points, rebalance. If not, leave it.
- Ask whether your target itself still fits. A change in your timeline, job security or health may justify a new mix. A rough year in the market, on its own, usually doesn’t.
Once a year is enough for most people. Checking monthly tends to produce lots of small trades with little benefit, and it invites tinkering.
Doing it without a tax bill
Where you make the trades matters. Selling investments in a taxable brokerage account can create capital gains tax. Selling inside a 401(k) or IRA generally doesn’t create a tax bill at the time of the trade. So when you can, do your rebalancing inside tax-advantaged accounts.
The gentlest method of all is to rebalance with new money. If stocks are above target, send your next few months of contributions to bonds until the mix comes back in line. Nothing gets sold, there’s no tax to think about, and on a portfolio where you’re still adding money every month, this alone often keeps you close enough to target that the yearly check takes five minutes.
This post is general information, not financial advice.