What is Investment Rebalancing and Why You Need to Do It

Here are some thoughts from the wonderful book The Bogleheads' Guide to Investing (I LOVED the book -- see my rating for details) on what investment rebalancing is and why we all need to do it. Let's start with a quick summary of what it is:

Rebalancing is simply the act of bringing our portfolio back to our target asset allocation after market forces or life events have changed the percentages of our various asset classes and segments of those classes.

Ok, let me take a minute and back up here a bit.

Asset allocation is simply the way you've decided to divide up your various investments based on your objectives, age, risk tolerance, etc. and it's a key part of maximizing your overall investment return. To find out more about asset allocation, see these links:

• Why Asset Allocation is Important and Market Timing Doesn't Work

• 4 Rules for Asset Allocation

• Using the Eighty/Twenty Rule for Asset Allocation

Now let's say you set your asset allocation at the beginning of 2006. At that point, you have all your investments divided up into the percentages you want in each investment category. But then, throughout the year, some go up, some go down and the percentages get all out of whack. So, you need to rebalance your portfolio (by putting more money in some investments and taking money out of others) to get back to your desired mix.

So, why should we rebalance? Here's what the book has to say:

• Rebalancing controls risk. It brings our portfolio back to the level of risk that we determined was appropriate for us and that we were comfortable with when we first established our asset allocation plan.

• Rebalancing forces us to sell high and buy low. We're selling the out-performing asset class or segment and buying the underperforming asset class or segment. That's exactly what smart investors want to do.

• Although it might be hard for some investors to understand why they shouldn't simply let their winners run, by doing so they'd be letting the market dictate the makeup of their portfolio, and thus their risk level.

• Rebalancing may also improve your returns, since asset classes have had a tendency to revert to the mean over time. By rebalancing, you're selling a portion of your winning asset classes before they revert to the mean (drop in price) and you're buying more of your underperforming asset classes when their prices are lower, before they revert to the mean (increase in value.) So, you're selling high and buying low.

This is an area I've been working on this year and will work on more in 2007. I'm in the process of rebalancing my entire portfolio (which hasn't been done in awhile) without killing myself in capital gains (accumulated over the years.) It might take a few years to get me EXACTLY where I want to be (I'm not so far off that it's a problem), but I'll get there eventually.

For more on making the most of your investments, see Best of Free Money Finance: Investment Posts.

Comments

[Savvy Steward]

I need to re-balance my 401k soon and I was wondering what your thoughts were if instead of selling and buying, I changed my future contributions in the funds that are lacking and allow them to catch-up until my allocation is where I want it to be. Or is it better just to sell some of my funds so that I can buy more of what I need?

[FMF]

I'm not sure how the "experts" would react to this idea, but personally I'm fine with it. It's something I've done as well from time to time.

[Russell Bailyn]

This conversation could be followed up with the distinctions between strategic asset allocation and tactical asset allocation. Strategic allocations are based on personal risk tolerance- they have your long-term objectives in mind. You rebalance periodically to re-align your portfolio with your attitude towards risk- which could remain the same, increase, or decrease. This counteracts a buy and hold strategy by taking risk tolerance as the #1 priority.

Tactical allocation is interesting in that it brings market forces into the equation. Perhaps it makes sense to allocate heavily into equities after a terrorist attack causes a broad depreciation in stock prices. This would be an attempt to capitalize on investor fears (which may create an inefficiency and opportunity to buy). At first, it struck me as a form of market timing, but I think it takes on a more mild form within the context of a portfolio. It could be done with index funds or ETFs.

[Russell Bailyn]

Oh- I almost forgot. Here is a great article on the "optimal portfolio rebalancing frequency.

http://www.efficientfrontier.com/ef/100/rebal100.htm

[ryan]

i rebalance every January, right after I write the checks for Roth/HSA contribuions.

according to Siegel, you do not lose anything by only rebalancing every 18 months, but with the money from 401K contribs/matches going in monthly, i didnt want all that sitting in cash for a year and a half.

so annually works well for me. I only keep 5 positions, so usually I am looking at 7 or 8 trades (three different brokerage houses) at $7 an equity and $17 a mutual fund roughly.

i am happy with the result.