You probably have a pretty good idea of how your investments have done lately. You may even track them daily. But to keep your portfolio in shape, you need to do much more than check the bottom line. You need to check the scale (or, your asset allocation).
It's easy for your portfolio to get out of balance. How your money is distributed among different types of investments - your asset allocation - changes over time as the market moves up and down. Before you know it, your mix of investments can be much different than it was when you started out.
By following a strict rebalancing plan you can essentially "time the market," not by increasing or decreasing equity exposure as the market becomes technically "overbought" or "oversold" or fundamentally over or under valued, but by simply selling high and buying low, just as you?ve always been taught! A strict rebalancing plan forces you to follow the theories and fundamentals of investing that you should be following, but just can't bring yourself to do and it inherently forces you to "time the market" over the long haul.
For example, if you wanted a 70-30 split between stocks and fixed income (bonds) in your retirement portfolio at the beginning of 2002, and all of a sudden at the end of 2002 you had a 55-45 split (due to overall equity market contraction during 2002), then you're taking on less risk then you wanted to (the reverse scenario may have occurred in 1999 or 2003). To get back to your original investment plan, you need to rebalance your portfolio; in this case back to 70% stocks and 30% fixed income. Just think where your portfolio might have stood at the end of 2002 if you had been following a strict rebalancing plan over the previous 7 years! Rebalancing also applies to sectors within an equity or bond portfolio. Check to see that your stock investments are still diversified. (Example: In the summer of 2002 the technology sector of your portfolio may have been under weighted, but, with the appreciation in technology stocks in 2003, it could have become over weighted.)
While rebalancing sounds simple in theory, it's often easier said than done. To do it, you usually need to sell investments in a winning category and invest that money in an asset class that hasn't been doing as well, a task that is not only psychologically difficult, but that may trigger capital gains taxes as well.
To avoid a hefty tax bill, try to sell some losers to offset your gains (not necessary in qualified plans which allow for tax deferred growth) or do some of your rebalancing with your deposits. In other words, if you want to boost the stock portion of your portfolio, contribute more new money to your stocks instead of bonds and bond funds.
So how often should you rebalance? There are two ways to go about this: (1) Rebalance annually or semiannually (rebalancing more often (such as monthly) may result in short-term gains (taxed as current income) and high transaction costs; or (2) rebalance your portfolio only when an asset class gets out of balance by a certain percentage (such as 5%). The second method is our preferred method, but requires a more consistent monitoring of the portfolio.
