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Rebalancing for the Real World

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Much of your investing success or failure will likely hinge on your asset allocation — how you deploy your investments among major asset classes such as stocks, bonds, real estate, and cash. Even more significantly, asset allocation is one of the few investment factors you control with any certainty. You can never be sure that you are buying or selling the right stocks at the right time. But you can be certain about the percentage of stocks, bonds, and other asset classes in your portfolio.

So choosing an appropriate mix of investments for your personal time horizon and risk tolerance can be key to maximizing your returns while minimizing your risk. Although numerous references are available on the topic of asset allocation, far less information is available on the details of maintaining that balance — rebalancing — as the market cycles over time. By “rebalancing” we mean changing your current asset allocation to move it closer to some previously-decided target allocation. (In a garden, if you decide that Morning Glories should be 10 percent, but they grow wildly and take up 25%, you cut them back to make room for other plants. That’s rebalancing.) Rebalancing is a potentially critical, but often overlooked, aspect of managing your portfolio for the long term.

Why rebalance? Years of research and practical experience indicate that asset classes perform on different, independent cycles. One will be up for a few years, then another will take its place. For example, from 2005 through 2007, international stocks were the highest-returning asset class. In 2008 they were the lowest. Instead, bonds were the leading asset class. But in 2009 bonds were second to last. Rebalancing theoretically “locks in” a portion of the profits earned by your winners, and ensures the losers are in a position to help, when their turn comes to shine.

Action Items

  • Don’t rebalance more frequently than annually, and consider waiting several years. Consider never rebalancing in your taxable accounts.
  • Don’t worry about small changes in your asset allocation, where “small” means at least 10%, and possibly even more, in your overall allocation.
  • Do most of your rebalancing during the course of adding new money, taking withdrawals, or reinvesting distributions, by buying laggards and selling winners.
  • But when an investment, especially an individual stock or sector holding, has delivered 2-3 years of double-digit returns, expect it will revert to the mean (or beyond), and sell some if you want.
  • As with choosing your individual investment holdings, consider diversifying your rebalancing strategies — the “when,” the “how,” and the “if.”

NEXT: Your Retirement Fuel Gauge

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