Portfolio Rebalancing

Even though rebalancing is one of the most important and valuable things an investor can do, it is likely that most investors don't do it, or at least not regularly.

Setting your asset allocation; the mix of stocks, bonds, mutual funds, insurance, and other securities, and cash in your portfolio; is your single most important task as an investor. The proportion in which you hold investments, like stocks vs. bonds (as well as different types of stocks and bonds) generally has a greater effect on your portfolio's returns and its volatility than the individual investments you choose. Which is why it's recommended that the first thing any serious investor do is create an asset allocation, or mix of assets, that's appropriate for his or her investment goals.

Balance and re-balance your mix

Let's use for an example a $100,000 portfolio. Let's say that you determine that a blend of 60 percent stocks and 40 percent bonds is right for you. We'll assume that over the course of the next 10 years, stocks earn 10 percent per year, and bonds earn 5 percent per year. Assuming you reinvested all your gains and did not add to or withdraw any money, the stock portion of your portfolio would be worth $155,624.55, while your bond holdings would be worth $65,155.79 for a total portfolio value of $220,780.44, before taxes. (for a compounding calculator click here)

However, now your portfolio is larger ($220,780.44) and it's higher risk. You started with an asset allocation of 60 percent stocks to 40 percent bonds but now you have an allocation of 70 percent stocks ($155,624.55) and 30 percent bonds ($65,155.79). In the late 1990's as stock returns were much higher, many investors found themselves with portfolios much more heavily slanted toward stocks then when they started. This affected them financially when stock returns flattened out.

If bond returns outpace stocks returns by enough of a margin, your portfolio could become more bond-heavy, or conservative. In our example, if stocks had returned 5 percent and bonds 10 percent in ten years you would be $97,733.68 in stocks and $103,749.70 in bonds totalling $201,483.38 and your allocation now is 48.5 percent in stocks and 51.5 percent in bonds.

This illustrates that by doing nothing your portfolio could easily change into something other than what you want. The way to avoid that is by having a portfolio review to rebalance your portfolio, or making adjustments to bring it back to its original proportions (or changing it to whatever proportions are appropriate if your goals have changed since you set your original asset allocations).

Portfolio reviews give you an opportunity to meet with your financial advisor and reevaluate your asset allocation. Do you now have enough of a "secure" nest egg that you want to invest more heavily in higher risk investments, changing your allocation? is there a downturn ahead and you want to be less risky? Do you have children entering college or other new expenses ahead? Now is the time to adjust your allocation to meet the changes in your financial status.

Rebalancing also has another benefit: it forces you to do something investors all say they want to do but rarely have the discipline to do: sell high and buy low. If stocks have a great year and bonds tank, then the stock portion of your portfolio swells in value, while the bond part shrinks. To bring your portfolio back in line, you've got to sell some stocks and put the proceeds into bonds.

There are basically three types of portfolio rebalancing:

Calendar Based Rebalancing

In this scenario you choose your time period; a month, a quarter, or a year; and at the end of that time period you review your portfolio to bring your portfolio back to its original proportions. There's no one way to tell which time period would give you the best results in terms of return vs. risk. As a practical matter, annual rebalancing is probably the best option for most people since it requires the least effort and, has the advantage of generating lower transaction costs.

Target based Rebalancing

In this scenario you set a range of percentage points around your various allocations, and you then review your portfolio to rebalance it if the asset allocation falls outside that range. In our example, if your allocation is 60 percent stocks and you set a range of plus or minus five percentage points, you would rebalance if stocks grew to more than 65 percent dropped to less than 55 percent of your portfolio. This method prevents your mix from ever straying too far from your original allocation, but it requires more monitoring on your part and can lead to unnecessary trading and transaction costs if the market is bouncing up and down a lot.

Tactics based Rebalancing

In this scenario, you incorporate your view of the market into your rebalancing decision. For example, you might set a potential range for your stock holdings of, say, 40 to 60 percent of your portfolio. If stock prices seem high to you, then you might rebalance your portfolio so your stock allocation falls back toward the bottom of that range. However, if stocks seem cheap to you, you would rebalance to push your stock holdings toward the top of the range.

While a case could be made for any of these methods, and your situation will be different, for most of us the method likely to generate fewer transaction costs is generally better than others, which results in calendar rebalancing on an annual basis.

Your Financial Advisor can help you to understand how the different strategies may impact you and when to step beyond them as financial circumstances dictate. Many Investment Companies may do your work for you on an automatic basis but that may or may not be right for you. Please see your Financial Advisor before implementing any change in your portfolio.

For example, Your financial advisor would know that when rebalancing in taxable accounts, you should first try to rebalance by adding any new money to whatever part of your allocation needs to increased. That way you can reduce or avoid the tax you incur when selling winners; or balance it against other expenses (shelter it from taxes).

NOTE: You should use rebalancing as a time to sell the losers from your portfolio. Since you are taking the effort to rebalance your portfolio, you might as well revitalize your it at the same time.