Now that we have the concept of having at least two low cost, diversified funds in our portfolio (from the previous article, Jumping Right In), the next concept is rebalancing.

Rebalancing is simply the idea that periodically, we bring the portion of our funds back to the balance we initially intended.

Let’s say you start with 30% bonds, 70% stocks.  Over the year, stocks do really well.  Bonds plod along like they do.  So now bonds are at 27% of your portfolio, stocks are 73%.

So you sell that 3% of the stocks, and buy bonds, bringing the balance back to 30%/70%.

Why do you do this?  For one, you decided 30%/70% is a good balance for you.  So in the long run, that’s your target.  It’s not good to let the balance slip too far.

Another benefit here is that you are inherently doing some selling high, and buy low.  Your stocks took off a bit, getting up to 73%.  So you’re taking a little profit there.  Bonds lagged a bit, so now you’re buying a little more at a good price.

Here’s another scenario.  Stocks plummet.  Your allocation is 45%/55%.  Stocks are cheap.  Rebalancing causes you to buy those stocks while they’re cheap..and you have funds available in your bond portion, ready to go.

Sticking to the method introduces some discipline to your portfolio.  Often, one a stock or fund is going up, it’s psychologically hard to sell it.  It’s doing so well, why would you want to sell it?  And that’s a trap, because eventually it’s going to head back down.  It’s easy to get too attached to your winners (less so with a fund than a stock, though).  This helps you methodically take some money off the table and put it somewhere where you’re more likely to get a better return.

The flipside is, when an asset class drops severely, like in 2008, it is really difficult to convince yourself to buy.  It feels like the world is crumbling, and seems crazy to buy something dropping.  But it’s the best time to buy.  Sticking to a rebalancing plan helps you do that.

Many things I’ve read say to do this annually.  Leave it alone the rest of the year.  Don’t mess with it; allow it to work.  Even ignore your portfolio entirely.  When you rebalance, depending on the type of account and funds, you may incur some costs.  You could have transaction fees.  Possibly even some taxes if this is in a taxable account.  Rebalancing more frequently will raise these costs, so doing it less frequently has some benefits.  Sometimes rebalancing when you have mutual funds has no added cost.

If you really can’t stand it, you could probably rebalance quarterly, but it’s not clear there’s really a lot of benefit to doing that.

If your portfolio is spread across multiple accounts, things get a little trickier.  You likely have a retirement account like a 401k or SEP.  But you may also have a Roth account, a rollover IRA from a previous employer’s 401k, or a taxable brokerage account.  You should rebalance the whole of these, not individually.  The goal is to have 30%/70% (for example) across the whole portfolio.

This can get a little more complicated with a 401k because often 401k’s have limited choices, especially when trying to get low cost index funds.  You may have to focus on the types of assets you can get in the 401k, then fill in other class in other accounts.

If your funds are only in a 401k, some 401k’s have a nice feature for rebalancing.  You can put it on autopilot.  You choose the allocation you want, and annually, it rebalances for you.  This could be a good option for some people.

Another possibility is to rebalance when an asset type is off your target by a given percentage.  Maybe you go with 5%.  So if your goal is 70% and it hits 75%, you go ahead and rebalance.  That takes more monitoring.

Rebalancing is an important strategy for your portfolio.  If you do it annually, which is not unreasonable, it takes very little time.




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