Rebalancing 101

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If you’ve ever seen those Ron Popeil infomercials for the Ronco Showtime Rotisserie, you may remember his classic tagline, “Set it and forget it!” While that strategy may work for chicken, it’s a terrible way to manage your investments. To achieve long-term financial goals, you should aim to regularly rebalance your portfolio.

Rebalancing is the act of buying and selling different kinds of assets to restore a portfolio to its original makeup. For example, assume your original asset allocation (basically a custom investment strategy based on your goals, risk tolerance and time horizon) was 60% stocks and 40% bonds. Furthermore, assume market fluctuations significantly increased the value of stocks and changed your allocation to 30% bonds and 70% stocks, potentially exposing yourself to greater risk than you initially planned. Rebalancing will simply bring you back to your original/most recent desired allocation.

Your retirement plan should employ at least a couple different asset classes, such as equity, fixed income, real estate, commodities, mutual funds, or cash. If you only invested in “safe” asset classes, say treasury bonds, your portfolio may not keep up with inflation, much less increase wealth. An all-stock selection, however, may carry too much risk for your appetite. Diversifying investments helps mitigate the risk of loss, because some of your assets may do better at the same time others take a nosedive. For example, when markets are feeling skittish, the price of gold tends to go up even as investors flee the stock market.

How your portfolio is divided will depend on several individual factors. An ideal asset allocation should consider your goals, investment horizon, and personality or risk tolerance. Someone who is saving for retirement will have a different allocation than somebody looking for aggressive growth or a reliable income source. How long you have to see results also matters. The closer you get to retirement, the more risk averse you should become. Money that you may need for living expenses within a few years should be kept in asset classes with more contained risk, such as fixed income. It’s best to work with a financial advisor who can go over your situation and help you determine an optimal investment strategy for your timeline.

Your work doesn’t stop with achieving an optimal asset mix, however. Over time, the proportion of assets in your portfolio will change even if you leave it alone. Putting too much of your wealth in one class leaves you exposed to the volatility of the dominant asset. For example, if your stocks vastly outperform other investments, your portfolio may end up with a disproportionate amount of high-volatility equity assets. If your aim is limiting equity assets to half your portfolio, you would rebalance this account by selling shares of stock and putting the proceeds towards other asset classes according to your outlined plan.

Your exact target allocation should be a distillation of your investment strategy. Warren Buffet famously told investors that his wife’s trust is composed of 90% index-tracking mutual funds with the remaining 10% in Treasury bonds. Someone whose goal is not leaving their wife a modest but reliable source of income after their death may follow a different tactic. Take a look at your current asset allocation, and ask yourself if it serves your purpose. If possible, work with a financial advisor to determine what strategy and mix of assets best fits your objectives, time horizon, and appetite for risk. You may also want to determine how often to review the allocation. While you may be tempted to rebalance often, frequent buying and selling of stock to achieve your target allocation may result in transaction fees and other costs that will eat away at profits.

Keep in mind that diversity does not have to be limited to asset type. You should diversify on as many levels as possible to minimize risk. Your aggressive investment strategy may involve mostly stocks. However, putting all your equity assets into one area of commerce leaves you vulnerable to that industry’s business cycle. To counteract that exposure, pick stocks with a mix of market capitalizations in various sectors and geographies.

Successful execution of a long-term investment strategy requires sustained discipline. Regular rebalancing will help you stick to your investment plan while minimizing risk and improving overall return.