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Asset Allocation
Make Rebalancing a Habit
By Roger Wohlner
CERTIFIED FINANCIAL PLANNER™ Practioner, Asset Strategy Consultants
We all know we should rebalance our portfolios periodically to ensure they stay in line with our targeted asset allocation. Why, then, is it so difficult for us to do this? The primary reason is that rebalancing goes against our basic instincts. With rebalancing, you are generally selling those investments performing well to purchase those that are underperforming, which just doesn't seem to make sense. It might help to remember that by rebalancing, you are following a fundamental investment principle - you are buying low (those investments that are underperforming) and selling high (those investments that are performing well).
Numerous studies have shown that rebalancing reduces the volatility in portfolios, often with increased returns. Keep in mind that you set your asset allocation strategy because you believed those were the appropriate percentages of various investments that you should own. Thus, you need to make rebalancing a habit so your portfolio doesn't become more risky than intended. There are three basic approaches to rebalancing:
Rebalance annually.
You can choose a date to rebalance, perhaps at the beginning of the year, when you receive your annual statements, or at the end of a specific quarter. On that date every year, compare your current allocation to your target allocation. Any allocations off by a designated percentage would require rebalancing. Once you have rebalanced, don't be tempted to make other rebalancing changes during the year.
Rebalance based on your views about current market conditions.
With this approach, rather than one specific percentage for each asset class, you might have a target range. For instance, you might allocate from 30% to 50% of your portfolio to large-capitalization stocks. Depending on your views of the market, you might want to allocate near the low or high end of that range. Thus, your allocations will change as your views about the market change.
Rebalance whenever your allocation moves from your target allocation by a designated percentage.
With this rebalancing method, you monitor your portfolio more frequently, perhaps monthly. Once your allocation moves from your target allocation by a certain predetermined percentage, you rebalance your portfolio.
With all three methods, you need to decide how much variation you are willing to tolerate in your portfolio before you rebalance. Several factors impact your decision:
Correlation - Correlation is a statistical measure of how one asset class performs in relation to another asset class. Assets that are not highly correlated can help reduce the volatility in a portfolio. Thus, the lower the correlation between assets, the less variation you should tolerate. Being off target will have a greater impact on your portfolio when the variation is between low correlation assets.
Volatility - You should tolerate less variation in assets that are more volatile, since this can quickly add more risk to your portfolio.
Costs to trade - Some assets may be illiquid or difficult to sell, making them expensive to trade. In those situations, you may be willing to tolerate more variation in your allocation percentages.
Taxes - Before rebalancing, you need to consider the tax ramifications of doing so. Especially if rebalancing would result in short-term capital gains subject to ordinary income taxes, you may be willing to tolerate more variation in your allocation percentages. However, there are other ways to rebalance without causing a taxable event, such as rebalancing in tax-deferred accounts, making new investments in underweighted assets, redirecting periodic income to the underweighted portion, or taking withdrawals from the overweighted portion.
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