Balancing Act
In my last post, I defined what it means to “manage” your portfolio. I wrote that once you have determined your asset allocation, based on your risk preferences, your work is basically done. There is no evidence to suggest that active trading will lead to better results (and plenty of evidence to the contrary).
But “basically done” is not the same as “completely done.” Of course, you will need to rethink your investments if something major changes in your life that causes you to fundamentally reset your goals. But more generally, the simple passage of time will require you to (occasionally) take action.
What is rebalancing?
To take a simple example, let’s assume that you settle on a mutual fund portfolio of 50% US stocks, 30% international (non-US) stocks and 20% US bonds. If your portfolio is $100,000 on January 1, that’s:
$50,000 in US stocks
$30,000 in non-US stocks
$20,000 in US bonds
But time marches on, the market moves up, down, sideways, and on December 31st you find yourself at:
$53,000 in US stocks
$40,000 in non-US stocks
$21,000 in US bonds
Great news: Your portfolio has increased to $114,000! But in terms of your asset allocation, things have gotten a bit out of whack:
46% US stocks
35% non-US stocks
18% US bonds
In this rather stylized example, because the three funds in your portfolio responded differently to market moves during the year (as they should!), the portfolio became a bit more edgy by the end of the year than what our fictional investor intended.
How to Rebalance
No worries! The fix is easy. To bring this portfolio back to its intended weights (50/30/20), it is simply a matter of selling shares from the “winner” (in this case, non-US stocks) and allocating the proceeds to US stocks and bonds:
That’s all there is to it. Calculate the “ideal” balance in each of your funds based on your current balance and intended asset allocation. Then buy/sell shares as necessary to bring your portfolio back into alignment. If this is all happening inside of a retirement account (an IRA, TSP or 401(k), for example), there are no tax consequences to consider. Managing your portfolio to maintain your asset allocation is no more complicated than that.
How often do you need to rebalance?
Once a year is fine. There has been research on this very question, and the conclusion is that there is no advantage to rebalancing more frequently, such as quarterly. Choose a date on the calendar, set a reminder on your phone, and leave it at that.
And sometimes you can just do nothing. In the example above, the non-US stock fund really outperformed, moving the allocation from 30% to 35%. But what if the movement off the target was less dramatic? You would be easily forgiven if you decided not to take any action if your various funds had only moved one or two percentage points away from their intended targets. Some investors set a threshold, perhaps 5 percentage points, below which they will skip the rebalancing exercise.
Can you just skip this rebalancing business altogether?
Yes, you can. Select a target date fund and leave the rebalancing task to a bot. (Which will also manage your portfolio to adjust as your retirement date approaches.) There are also low-cost index funds available, known as balanced funds, which hold a constant ratio of stocks and bonds.
Managing an investment portfolio does not need to be complicated at all, once you are clear on your objectives and your level of comfort with investment risk.
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