How to rebalance your portfolio

(Money Magazine) -- Question: I plan to retire in a few years, so my target asset allocation is 40% stocks and 60% in bonds, cash, real estate and other investments. My question: How should I rebalance my portfolio? Should I bring my allocations back in line at some trigger point? Should I do it annually on my birthday or some other date? Is there some other method? I would be interested in your thoughts on this. -- R.B., Northbrook, Illinois

Answer: Ah, rebalancing. It's one of those activities, like cleaning out the garage or organizing your files, that people talk about a lot but don't always get around to doing.

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Walter Updegrave is a senior editor with Money Magazine and is the author of "How to Retire Rich in a Totally Changed World: Why You're Not in Kansas Anymore" (Three Rivers Press 2005).

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Maybe that's because, like you, investors aren't sure how to about it. Or perhaps they're unclear about what benefits rebalancing actually offers. Then again, it could be because we simply don't think much about restoring our portfolio to its target asset allocation when the market is going gangbusters or even just moving sideways. It usually pops up on our radar screens only after the market's fallen off a cliff. Then we start to think, "Hmmm, maybe I'd be better off now had I known how to rebalance my portfolio and actually done it."

Whatever the case, let's see if we can shed a little light -- and come away with some practical tips -- on this important but often neglected and misunderstood practice.

As you note, there's no shortage of rebalancing techniques. Some people advocate calendar rebalancing. That could mean bringing your portfolio back to its intended mix of assets once year on a date you'll likely remember -- your birthday, an anniversary, whatever -- or doing so at the end of each quarter or even every month. Others recommend rebalancing whenever the asset classes in your portfolio stray from their target percentages by a certain threshold, say, five percentage points. So, in your case, you might rebalance any time your stock stake sinks to 35% or less of your portfolio.

But there's a hybrid approach as well, the "time and threshold" method, in which you check your portfolio once a year, quarter or month, but rebalance only if it has strayed from its proportions by the margin you've set. Which method is best?

At the risk of sounding wishy washy, I don't believe anyone can say with certainty which rebalancing method is superior. For example, when T. Rowe Price researchers looked at monthly vs. annual rebalancing for a 60% stock-30% bond-10% cash portfolio for the 10- and 20-year periods ending at the beginning of 2009, they found that you would have ended up with a higher ending portfolio value rebalancing annually rather than monthly. But that doesn't mean annual rebalancing will always lead to a bigger balance for all portfolios for all time periods. Nor does it mean that a bigger ending balance is the appropriate gauge of success. There's also the matter of risk, or how much you're willing to see your portfolio's value jump around.

To get an idea of how factors like volatility, costs and market conditions affect different rebalancing methods, take a look at this recent Vanguard paper (or, if you really like to get into the weeds of this sort of thing, check out the version for institutional investors.

What you'll find after reading through this study is that no rebalancing technique stands out as the clear winner. Indeed, I think the study's conclusion sums up things pretty well: "Just as there is no universally optimal asset allocation, there is no universally optimal rebalancing strategy. The only clear advantage as far as maintaining a portfolio's risk-and-return characteristics is that a rebalanced portfolio more closely aligns with the characteristics of the target asset allocation than with a never-rebalanced portfolio."

That last sentence, by the way, is a fancy way of saying that the real benefit to rebalancing isn't that it guarantees you a higher return or fatter account balance. Since stocks tend to rise over the long term, any rebalancing out of stocks would tend to lower your return over very long periods.

Rather, the payoff from rebalancing is that it prevents your portfolio from getting out of whack due to the normal ebb and flow of the market or, to put it another way, from becoming riskier than it ought to be when the stock market is soaring and more conservative than it should be after stocks have been hammered.

Maintaining an appropriate risk level is always important, but it's especially so for someone in your position. After all, the last thing you want when you're nearing retirement is to go into a big market decline with a portfolio that's bloated with stocks (which was the case for 22% of 401(k) participants aged 56 to 65 who had more than 90% of their accounts in stocks going into the 2008 market downturn, according to EBRI.

Keep it simple: Given all this, what rebalancing strategy should you follow? Well, since no one technique clearly stands above the rest, I'd be inclined to opt for simplicity. I think the easier rebalancing is, the more likely investors are to actually do it.

So I'm a fan of annual rebalancing. I'd choose a date close, but not too close, to the end of the year -- say, Thanksgiving -- so I'd have plenty of time to harvest any investment losses for tax purposes as part of my rebalancing effort.

I'd also incorporate the idea of establishing a threshold, and rebalancing only if my allocations got out of kilter by, say, five or so percentage points. After all, it's not as if your portfolio is doomed to dismal performance or you're radically changing its risk profile if your 40% stock allocation slips to 37.5%. Finally, before selling any positions to rebalance (especially in taxable accounts), I'd see if I could bring my portfolio back in line by directing new money to the appropriate assets.

That said, more frequent rebalancing does have the virtue of keeping your portfolio closer to its target allocations and thus maintaining a more consistent risk level. So if you know you'll be responsible enough to monitor your portfolio more frequently than once a year and make adjustments as necessary, then I don't see any harm in going to quarterly or even monthly rebalancing or, for that matter, rebalancing whenever your allocations stray from your targets. Many 401(k) plans and other retirement accounts now offer an automatic rebalancing option, which can make it easier to maintain a regimen of quarterly or monthly rebalancing.

One more thing to keep in mind is that as you age, you probably want to gradually lower your exposure to stocks. So instead of simply rebalancing back to whatever stocks-bonds mix you've previously settled on, you'll also want to consider whether you need to shift your target mix a bit and make it a bit more conservative as you near or enter retirement.

So check out the studies I mentioned and give some thought to how much time and effort you're realistically willing to devote to keeping your portfolio in shape. Then choose a rebalancing strategy that suits you and stick to it.

Who knows, once you've got your rebalancing act down, you might even get around to organizing those files.