Paul Merriman
Sound Investing For Every Stage of Life 

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6 Things You Should Know About Rebalancing

Reprinted courtesy of

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The yearly rebalancing of your investments is a dull chore that’s tempting to postpone. Investors who put it off too long, however, can live to bitterly regret their procrastination.

Here are six things you need to know about rebalancing:

1. Risk

The main reason to rebalance isn’t to make more money; it’s to control your exposure to risk.

The most fundamental relationship that needs to remain properly balanced in a portfolio is the ratio of stock funds to bond funds. Imagine that your target allocation is 60% stocks (for growth) and 40% bonds (for income and stability).

If you never rebalance, the long-term higher return of stocks will make your portfolio progressively more risky. After 10 years, stocks could easily make up 70%, and bonds only 30%. After 25 years without rebalancing, stocks could make up more than 80% of your holdings.

That might give you favorable cumulative gains, but it will also give your portfolio substantially more risk. In a severe bear market, a very large majority of your portfolio will shrink, instead of only 60%.

If you never rebalance, your risk exposure will almost certainly keep going up as you age. That’s the opposite of what is normally recommended.

2. Asset classes

You can also rebalance two equity asset classes, for example large-cap stocks and small-cap stocks. Both are expected to have favorable long-term returns, but to some extent they may go up and down at different times (non-correlated, in other words).

If you rebalance non-correlated asset classes that have similar long-term returns, it is possible that rebalancing will produce a higher return than that of either individual asset class by itself.

When one has significantly higher returns than the other, rebalancing is likely to leave you with a return somewhere between the individual returns of the two.

3. Buy low, sell high

A time-honored investing formula calls for buying low and selling high. Rebalancing is the best way I know to do that. If the asset classes you own have a long history of bouncing back after major declines, this will likely pay off.

In 2008 and 2009, bonds became very popular while stocks suffered one of the largest loses since the 1930s. Few investors were happy that they needed to sell some relatively safe bondholdings to buy more stock funds. However, those who made this difficult move were rewarded well when the market rallied in 2009 and 2010.

4. Tax consequences

You may need to pay attention to the tax consequences of rebalancing.

Taxes aren’t a problem inside any kind of IRA or 401(k) or similar retirement plan. But in a taxable account, any sale of securities is potentially a taxable event.

That’s especially important to keep in mind, because when you rebalance you will normally be selling assets that have appreciated. That means taxable gains.

The most tax-efficient way to rebalance is by allocating new investments to funds that have been underperforming. Here’s another tip: If you own mutual funds that pay out dividends and capital gains, you can take those distributions in cash instead of in automatic reinvestments. Then use the cash to invest in other holdings that are below your target levels.

If you’re retired and taking distributions, you may be able to keep your accounts in balance by withdrawing money from your most profitable funds.

However, in many cases these strategies won’t be enough. To restore your holdings to their target percentages, you may have to sell, generating taxable gains. Because long-term gains are taxed at relatively favorable rates, your tax bill will be lower if you sell only assets that you’ve owned for a year or more.

5. Timing

Historically, the first quarter is the best time to rebalance. Many experts have looked at this question and agree that historically, the first quarter of the year, when the market tends to do well, is the most favorable time to rebalance.

Plus, pushing capital gains into the following year will also postpone any tax you will owe on those gains.

6. Frequency

The rebalancing question I hear most frequently is how often should rebalancing be done. There’s no absolute right answer, as it’s a trade-off between risk and return.

In theory, the longer you postpone rebalancing, the higher your return will be. If you never rebalance at all (see above) you may get the highest return of all. But by doing that you would be gradually adding more risk to your portfolio.

At the other extreme, you could rebalance your funds every business day. That would absolutely prevent your level of risk from deviating from your targets. However, it also would absolutely prevent your higher-performing assets from compounding.

I generally recommend rebalancing once a year. That will avoid the tax cost of having short-term taxable gains. And it will let your “winning” asset classes do their thing when they are on a roll.

I have computed long-term results assuming annual rebalancing and (with exactly the same portfolio) assuming monthly rebalancing. Over 44 years, the compound return was 10.3% with annual rebalancing versus only 9.3% with monthly rebalancing.

That difference is a big deal. Over the 44 years, a $100,000 initial investment grew to about $8.2 million with annual rebalancing but only to about $6.8 million when rebalanced monthly.

It isn’t hard to understand the reason for the difference. When you rebalance every month you are taking the excess equity gains (in most months equities do better than bonds) and moving them to the safer (and less profitable) bond funds. Such short-term rebalancing never allows the best performing asset classes to take off and run.

Annual rebalancing will allow you to let the good times roll with the asset classes that are doing well while at the same time you let the poorer performers continue their struggle longer.

Why let your investments struggle? Simple: This lets the stragglers get relatively cheaper before you buy more of them.

Richard Buck contributed to this article.


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