Explaining the logic of rebalancing your portfolio is pretty easy. Applying that logic, however, is not easy at all. Here's how you should rebalance.
Rebalancing is simply setting an asset allocation target and then adjusting your portfolio back to that allocation target. For example, a portfolio target at, say, 60 percent equities and 40 percent fixed income would have changed dramatically during the past decade. During the five raging bull years of 2003 - 2007, rebalancing would have meant reducing your exposure to equities and buying those boring bonds. Then, after the 2008 crash, you'd have had to buy equities. Which brings us to the latter part of this year, the fastest bull market since the great depression, where you'd again have to sell equities.
Why rebalancing is so hard
As mentioned, it's simple to calculate the 60% equities allocation, but maintaining it through rebalancing is what trips investors up. Following the herd is as instinctual to us as the "fight or flight" instinct is, and it compels us to buy when everyone else is buying and sell when the Wall Street herd is in a panic. Few had the cash and courage to buy equities during those code red days between October 2008 and March 2009. Tough as it is to go against the herd, rebalancing is one way that virtually assures you will be a true contrarian.
When to rebalance
Some people suggest that you need to rebalance often, such as every month. Others feel you only need to do it every couple of years. Personally, I think time is the wrong dimension. I suggest the trigger for rebalancing is more a matter of how far you are off your target allocation than the time since your last rebalancing.
I recommend setting a tolerance limit and then rebalancing once that limit has been breached. For example, your 60 percent equity target could have a five percentage point tolerance limit. Thus, you would buy equities if it fell below 55 percent and sell if it rose above 65 percent.
Using a tolerance limit wouldn't have you doing a thing in a boring year, like 2007, where stocks and bonds both clocked a similar performance. You'd have been pretty busy, however, during the last couple of years.
How to rebalance
Selling to rebalance can cause tax consequences. Thus, it's better to use your tax-deferred accounts whenever possible. If you must recognize a taxable gain, try to sell something that gives you a long-term gain which may be taxed at a lower rate.
If you are in the accumulation mode and are putting money away for retirement, you don't have to wait until the tolerance limit is reached. In a bull stock market, start buying more bonds. Conversely, in a bear market, buy more equities.
Remember that rebalancing doesn't work every year. But it has a history of working for the long-term. Everyone loves to see themselves as a contrarian rather than a follower. Rebalancing allows you to truly become one, and to finally wave goodbye to the herd.
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