When Portfolio Changes Do—and Don't—Make Sense

How do you know it's time to make a change in your investment portfolio?

Adjusting our portfolios and making sound buy or sell decisions can be fraught in the best of times. Markets are always moving, with bulls giving way to bears, and back again. In this ever-shifting environment, the emotional pressure to avoid sins of either commission or omission against our future financial selves can scramble our decision-making powers when they matter most. We wouldn't want to sabotage our goals by loading up on a loser in a surge of excessive exuberance or dumping a potential future winner in a moment of fear.

Experienced investors have probably also noticed that in our information-saturated age the pressure to act—whether to buy or sell—comes from outside, as well. The financial news touts hot new stocks, industries, or technologies, and then, depending on the day, issues dire-seeming warnings about them. The rumors and trends that explode out of social media can drive the market action into wild cycles of boom and bust, a dynamic that has become so routine that market watchers coined the term "meme stock" to characterize social media-driven investment-narratives.

So, if our guts and the outside world sometimes seem to be conspiring against our peace of mind, it helps to have a framework for making more grounded decisions.

Here, we'll address some of the impulses that can make us act at the worst of times and offer some occasions when changing up our investments can actually make sense.

Whenever you feel the urge to start trading in response to sudden market moves or even stories in the cultural air, it's probably best to interrogate your motives. Less-than-creditable emotions like panic and greed might be at work. Mental shortcuts rooted in cognitive or behavioral biases can make harmful moves seem rational.

Here are some examples:

• Fear of missing out. If you're tempted to change your investments—say, by piling into a hot stock or cryptocurrency during an upswing—because friends or family are doing it and you don't want to miss out on quick, easy gains, you may be experiencing herd mentality bias. The problem is that aggressively chasing trends just means outsourcing your due diligence to the crowds, as well as exposing yourself to the risk of buying high and then getting hit with a sharp reversal. News headlines and the "vibe" among investors aren't good benchmarks for your own needs or performance. Going with the flow can mean bypassing the research and analysis that are vital in investing.
• Overconfidence. This may seem like an easy one, but experienced investors can be tempted to overestimate their abilities when it comes to money matters, tricking their brains into making risky bets. Overconfidence can also potentially also expose you to higher costs if you end up frequently buying and selling assets.
• Overreacting to recent events. Recency bias is the tendency to over-emphasize experiences that are top of mind—even if they're not the most relevant to your goals. Recency bias can lead you to deviate from your carefully laid investment plans and make irrational decisions, which may have damaging long-term consequences. For example, if the stock market recently plunged, you may be tempted to rip up your allocation in favor of a more conservative arrangement. The risk is that you could become more focused on that memorable rough patch than on making a dispassionate assessment of the market's future prospects.
• Loss aversion. Loss aversion makes us overly sensitive to potential losses relative to opportunities for gains. This can affect our investments in a few ways. On one hand, we might become so sensitive to even the possibility of losses that we become conservative to the point of undermining our goals. This is especially true for investors who adopt overly conservative allocations before they have adequate savings for retirement, robbing themselves of the growth potential they might need to support their lifestyles. On the other hand—and somewhat perversely—loss aversion can also cause us to take on extra risk when we're down. The idea here is that our fear of locking losses could drive us to make even riskier decisions than we normally would in the hope of bouncing out of a hole.

These are just a few of the prompts to action that can harm us more than help. Resisting them can be the first step to insulating our portfolios from unwarranted moves.

Of course, that's not to say you should never act. When you invest for specific goals by creating a target asset allocation, you will have to make moves to help keep your portfolio on track over time. The question is under what circumstances. Here are a few when acting can make sense.

• Routine periodical rebalancing. Rebalance your portfolio back to your strategic allocation at least annually by trimming down positions that have grown in value while beefing up those that are falling short. For example, if your tech shares have boomed, while your energy shares have lagged, you could sell some of the tech and add more energy. If this sounds boring, well, the discipline is the point. Rebalancing is designed to keep your portfolio's targeted allocation across various asset classes, and intended level of risk, consistent over time. If you never rebalance your portfolio, you're letting the market dictate its level of risk rather than being intentional about it.
• Rebalancing to correct portfolio drift. This is a corollary of the annual approach, but for situations when markets have moved so much that waiting a year could prove risky. The idea here is to act when an allocation to a major asset class moves outside a defined tolerance band of, say, + or –5%. So, if you had a traditional allocation of 60% stocks and 40% bonds, that would mean you could consider rebalancing if your stock holdings grew to account for 65% or more of your portfolio (or your bonds shrank to 35% or less). To be clear, this kind of drift within a calendar year is pretty rare. It's also worth noting that in professionally managed portfolios, more volatile asset classes might be allowed to drift a bit more than 5%, while less volatile ones could be subject to stricter limits. Whatever the percentage you decide on, the point is to make your trigger mechanical, not emotional.
• Reallocating when your circumstances change. Inherent in the idea of having a target asset allocation keyed to a financial goal—retirement, college, buying a home, etc.—is that you hope to one day reach that goal. When that happens, your financial situation will have changed and a new allocation may become necessary. For example, you might have a large allocation to growth-oriented stocks during your working and saving years. But then when you actually retire, your goal might become preserving and spending what you have. That doesn't mean you would suddenly jump from an portfolio to a completely conservative one—you might still want to keep a sizeable allocation to stocks to help ensure some potential growth and hedge against inflation even in retirement—but you probably don't need to be as geared toward growth. Getting married, getting divorced, changing jobs, receiving a large inheritance, the loss of a spouse: Any financially significant change could merit some tweaks. Ultimately, the portfolio should adjust to suit your needs, not the market.

It's hard to put biases and emotions aside when investing, especially if your future depends on the results. For some investors, decisions about their portfolios can feel high stakes, which adds pressure that can do a lot of harm. That's one reason we believe everyone, regardless of their age or amount of assets, can benefit from drafting a plan. A plan can help keep you on track even when a gut feeling, rule of thumb or reasonable-seeming mental shortcut offers up an easy answer.