Last Updated Apr 14, 2010 9:41 AM EDT
There are no sure things when it comes to investing, but regularly rebalancing your portfolio comes pretty close.
Over the long term, properly managing your portfolio’s asset allocation can deliver a 0.5 to 1.0 percentage point annual bonus compared to what you’d earn on the same portfolio that’s left alone, according to my calculations. This might not sound like much, but the dollars you’d pocket in a sizable portfolio can really add up.
Let’s assume you had invested $100,000 in 1999 — 60 percent U.S. and foreign stocks and 40 percent bonds. By rebalancing once a year over the next decade, you could have boosted your annualized return from 3.2 percent to 3.7 percent. That would have amounted to an extra $7,000 over those 10 years.
This plan doesn’t require any special trading skills or ability to forecast short-term market trends (as if anyone could). You just need to own a broad mix of asset classes and adjust the mix regularly to bring the portfolio back to your original allocation. In this case, 1+1 really does equal 3.
Why Rebalancing is Tough
What’s the catch? You need patience and an above-average capacity for thinking independently. Rebalancing means making (and learning to live with) investment decisions that are out of step with the crowd, since you need to sell when others are buying and buy when others are selling.
This sometimes means mustering “industrial levels” of contrarianism, says William Bernstein, author of The Investor’s Manifesto. “It forces you, in general, to buy low and sell high, no matter what the talking heads are saying,” he adds. In the short term, rebalancing can make your investment results look mediocre — if not downright foolish — compared with more aggressive momentum strategies.
For example, rebalancers sold stocks in the heady days of 2007, since their portfolios were out of whack due to the market run-up. Then they bought equities during the severe crash of late 2008 and early 2009, when their pummeled portfolios were light in stocks on a percentage basis.
The payoff only became obvious by the end of last year, after the extraordinary stock market rebound. As MoneyWatch blogger Larry Swedroe notes, investors who had the courage to rebalance over the past few years have now recovered a much greater share of their losses than investors who did nothing.
Could you have made those rebalancing moves? Did you? “Most people don’t have the discipline,” says Jeff Troutner of Equius Partners, a wealth management firm in Novato, Calif.
Fortunately, markets rarely deliver such extreme results, so the impact of rebalancing tends to be more subtle. The benefits come slowly, usually over a business cycle or two — five to 10 years at a minimum.
The first step in rebalancing is figuring out how all your investment accounts — from 401(k)s to IRAs to mutual funds and stocks — are allocated now. Calculate what percentage of your portfolio is in stocks, bonds and cash and compare those numbers to your desired allocation. A more expansive exercise includes other investments, such as commodities and real estate investment trusts, and divides stocks and bonds up into narrower slices, such as domestic and international.
This can get a little tricky if you own balanced or target-date funds, since they hold stocks and bonds. You can usually find a recent summary of their stock/bond splits on the fund’s web site. Morningstar’s useful Instant X-Ray tool provides the asset allocation of all mutual funds and ETFs.
How Often to Rebalance
For most investors, rebalancing once every year or two is enough. (Do it when you have statements for all your investments for the same time period.) More frequent rebalancing can sock you with higher taxes and trading costs.
If you are in the habit of monitoring your portfolio closely, you may also want to rebalance if huge market moves send your asset allocation way out of whack. For instance, if you want to keep half your portfolio in stocks, trim the stock allocation if it hits 70 percent or buy if it falls below 30 percent. Under most circumstances, annual rebalancing will prevent such wild swings from happening, however.
Where to Rebalance First
When you need to sell parts of your portfolio to rebalance, start with your tax-deferred accounts, such as your 401(k) and IRA, where you won’t owe any taxes on the gains. In your taxable accounts, tax-loss harvesting can help. When you need to sell those securities or funds, look first for ones with embedded capital losses. They’ll offset any taxable capital gains you generate elsewhere in your portfolio.
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