Your portfolio: A rebalancing act

Your portfolio can easily go out of whack from the original investment allocation you wanted. Walter Updegrave looks at how to get the rebalancing equation right.

By Walter Updegrave, Money Magazine senior editor

NEW YORK (Money) -- Question: About six months ago, I invested a chunk of money into four separate mutual funds. When would you recommend adjusting the balances so each fund is back to its original percentage of my portfolio? - John R., Arlington, Virginia

Answer: We're talking, of course, about rebalancing, which I consider the Rodney Dangerfield of investment strategies. It's so simple and has so many wonderful benefits, yet it gets no respect. Relatively few people do it as regularly as they should, and many just blow it off altogether. Which is why it's so nice to see someone like yourself who not only wants to rebalance, but wants to make sure he's getting it right.

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But before I get to the issue of how often you might want to rebalance, let's first make sure that the way you've divvied up your money makes sense. After all, if all you're doing is rebalancing back to a stocks-bonds mix that doesn't make sense for someone in your situation, what's the point?

You say you've bought four separate mutual funds. That's fine, but it doesn't necessarily mean you're properly diversified. Many people make the mistake of buying several funds with similar strategies - say, an aggressive growth fund, a technology fund and a small-cap growth fund - and end up with a portfolio with many overlapping holdings, not to mention one that's heavily weighted toward riskier small company stocks and growth issues.

Ideally, you want a portfolio that contains a nice blend of large and small stocks, growth and value and maybe a dollop of foreign shares, plus bonds. To get an idea of how your portfolio breaks down along these lines, just plug your holdings into Morningstar's Instant X-Ray tool. You can then go to our Asset Allocator tool to see how your portfolio's mix compares with the one we suggest. The two don't have to match exactly.

But if the asset mix in your four funds is way off our suggestions, you ought to at least consider making some adjustments. Of course, once you've gotten your baseline mix, or asset allocation, down, it's only a matter of time before it naturally slips out of whack.

When the stock market is on a run, your stock holdings will become a larger percentage of your portfolio, which means your portfolio will become more risky. When bonds outperform stocks, then your bond holdings will swell relative to your stock holdings and your portfolio will become less volatile.

By rebalancing, you bring your portfolio back to its original proportions. This provides two benefits. The first is that you get back to the level of risk that's appropriate for you. The second is that by selling assets that have gained in value (and thus become a bigger part of your portfolio) and plowing the proceeds into assets that have lagged, you are practicing the oft-cited but not so often followed dictum of buying low and selling high. In some cases, as you can see by clicking here, rebalancing can actually boost your return while simultaneously reducing risk.

Not that shooting for the highest gains is the reason to rebalance. It isn't. The real point of the exercise is to maintain a steady investment strategy in the face of fluctuating markets.

Rebalancing can also protect you from the big losses you might sustain if your portfolio becomes heavily weighted toward one asset over time that then gets whacked (think growth stocks in the late 1990s).

So how often should you perform this rebalancing act? Well, I don't know of any definitive answer. But there are three generally accepted methods of rebalancing, one of which I don't recommend, another that I consider okay but probably too much of a hassle for most people and a third that I think is probably the best option of all.

Here's a rundown of those options starting with my favorite.

Calendar rebalancing. With this version of rebalancing, you set your asset mix - say 65 percent stocks and 35 percent bonds - then pick a time period of perhaps a month, a quarter or a year and then bring your portfolio back to your original mix at the end of that period. That's about it.

What I like most about calendar rebalancing is its simplicity. The less complicated a strategy is, the more likely people are to follow it. Which is why I also like the idea of rebalancing just once a year. You pick a date - a birthday, anniversary, New Year's Day (or the day after if you're a party hound) - and rejigger your portfolio on that day every year. Easy to remember, and not too burdensome.

Doing this every month or even every quarter could become burdensome given all the other activities you're probably juggling. So my recommendation for most people is to just pick a date you'll remember and rebalance on that day every year.

Target rebalancing. The idea here is that you decide on percentages for various asset classes, but you then set a range of, say, five percentage points or so on either side of your target. You then rebalance back to your original mix when an asset class falls outside of that range. So, for example, if your starting blend was 65 percent stocks and 35 percent bonds, you might rebalance if stocks drop to 60 percent of your holdings or rise to 70 percent.

Theoretically, this style of rebalancing makes perfect sense in that it doesn't allow your portfolio ever to drift too far from your original allocations. But to pull this off you have to monitor your portfolio fairly closely, and you could end having to rebalance several times over the course 12 to 18 months, which could drive up transaction costs. As a practical matter, I'm not convinced most individual investors would follow through, especially if they're dealing with a variety of asset classes - large-cap, small-cap, foreign stocks, investment-grade bonds, high-yields bonds, etc.

Tactical rebalancing. This is similar to target rebalancing, except in deciding whether to rebalance you also factor in your expectations for the market. Let's say you figure that, depending on your view of stock values, your stock holdings could be anywhere from 50 percent to 70 percent of your portfolio. If your stock holdings had climbed to 65 percent of your portfolio and you felt that the stock market was getting frothy, then you might rebalance back to 60 percent or even closer to 50 percent.

If, on the other hand, you believed stocks were still relative bargains, you would give your stocks the chance to continue climbing to the upper limit of your range. To me, though, this system seems to undercut the underlying premise of asset allocation and rebalancing. Which is that you don't know what the financial markets are going to do in the future, so you deal with that uncertainty by setting an appropriate mix and largely sticking to it.

To my mind, another benefit of rebalancing is that it takes some of the emotion and guesswork out of investing, so you don't end up chasing hot sectors or trying to figure out which ones are likely to outperform. I think tactical rebalancing puts at least some of the emotion and guesswork back in. It's not as bad as outright market timing. But it's uncomfortably close.

If you're rebalancing within a tax-advantaged account like a 401(k) or IRA, you don't have to worry about taxes. So you can get your portfolio back into shape by simply selling off shares of winning investments and plowing the proceeds into losers. (By the way, a growing number of 401(k) plans offer automatic rebalancing or the plan will do it for you if you ask. If your plan has a rebalancing option, take advantage of it.)

But if you're dealing with money in a taxable account, you want to be more careful. If the proportions are off only slightly and selling could trigger taxable gains, you're probably better off restoring your portfolio's proportions by just putting any new money you're investing into the laggards.

If that's not likely to get your portfolio to where it needs to be, you can always try to sell the shares that will result in the lowest tax bill - for example, shares that cost you the most and therefore will generate the smallest gains (or even losses) or ones you've held longer than a year so any gains will be taxed at more favorable long-term capital gains rates.

If your portfolio's not seriously out of whack, you might even want to postpone rebalancing or skip it until the next time rolls around. After all, it's not like the shift of a percentage point or two in your holdings is likely to have a major impact on your portfolio's long-term performance.

Of course, you can sidestep the whole issue of rebalancing by investing in funds that do it for you, such as target-date retirement funds, which you can learn more about by clicking here and here. And, in fact, I think this is a perfectly acceptable way to go, especially if you know that, otherwise, you're probably not going to do it at all. Top of page

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Most stock quote data provided by BATS. Market indices are shown in real time, except for the DJIA, which is delayed by two minutes. All times are ET. Disclaimer.

Morningstar: © 2014 Morningstar, Inc. All Rights Reserved.

Factset: FactSet Research Systems Inc. 2014. All rights reserved.

Chicago Mercantile Association: Certain market data is the property of Chicago Mercantile Exchange Inc. and its licensors. All rights reserved.

Dow Jones: The Dow Jones branded indices are proprietary to and are calculated, distributed and marketed by DJI Opco, a subsidiary of S&P Dow Jones Indices LLC and have been licensed for use to S&P Opco, LLC and CNN. Standard & Poor's and S&P are registered trademarks of Standard & Poor’s Financial Services LLC and Dow Jones is a registered trademark of Dow Jones Trademark Holdings LLC. All content of the Dow Jones branded indices © S&P Dow Jones Indices LLC 2014 and/or its affiliates.