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While the stock market has dropped, the bonds in my retirement account have almost doubled in value. I know I should rebalance, but I'm not sure when to do it. Should try to time it for when I think stocks will rebound? Or should I rebalance at the same time every year or, for that matter, several times a year?
-- Roger H., Yonkers, New York
How nice to get a question from someone who actually owned bonds before the stock market fell apart. You, my friend, are living proof of the benefits of true diversification -- that is, spreading your money among a variety of assets instead of making an all-or-nothing bet on whatever asset class happens to be hot.
During the go-go '90s, of course, asset allocation was dismissed as an outdated notion by New Era investors. Or, to the extent it still existed, some investors made a parody of the concept, believing they were diversifying if they added some AOL and Intel shares to their JDS Uniphase and Cisco holdings.
Of course, one of the core tenets of building a diversified portfolio is preventing that portfolio from getting too far out of whack. Why? Because if you're building a portfolio the right way, your original asset allocation, your mix of assets, should be based on such factors as your tolerance for risk, your need for long-term growth and the number of years until you need to tap your portfolio.
In the real world, however, your mix changes over time. When stocks are generating higher returns than bonds, then your portfolio naturally becomes more heavy with stocks. And when the reverse happens and bonds dominate -- as has been the case since 2000 -- then you end up with a higher percentage of bonds.
And that's where rebalancing comes in. It's the way to bring your portfolio back to its original proportions.
The right way and the wrong way to rebalance
Now, there are a number of ways to approach rebalancing. But first let me dismiss what I believe is the absolute wrong way -- namely, trying to time your rebalancing decision to coincide with a rebound in stock prices or, for that matter, the price of any asset. That is not rebalancing; that is making a guess about the future direction of the market.
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The whole idea behind diversifying and rebalancing is to avoid such guesses. Indeed, building a diversified portfolio and then keeping the proportions relatively constant is an admission that you can't profit by jumping in and out of different assets. So that puts me in the "mechanical" rebalancing camp -- that is, you pick a time period and then rebalance your portfolio without regard to what's going on in the market.
Some advisers like to rebalance monthly, others quarterly, some yearly. I'm sure you can make a case for any of those frequencies, and possibly others. But there are some practical concerns that, I believe, argue for less rather than more frequent rebalancing.
To the extent you're incurring costs -- commissions, transaction fees, spreads between what pay for investments and what you get when you sell -- then the more you rebalance, the higher those costs will be. Taxes are another consideration, since selling securities can generate taxable gains (unless you're rebalancing in a tax-advantaged account like a 401(k) or IRA).
And then there's the matter of how much work you want to put into your investments. If you have a sizeable portfolio, rebalancing monthly can lead to a lot of record keeping and a possible headache at tax-filing time.
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So what's the answer? I'm very happy with annual rebalancing, preferably just before end of the year so you have a chance to possibly trim your tax bill by offsetting losses and gains. But I couldn't say that quarterly rebalancing would be a lousy choice, though I'm not willing to put in the extra work to do it. As for monthly well, lets just say I hope you have plenty of time on your hands.
Whatever frequency you choose, stick with it -- and don't give in to the temptation to rebalance earlier or later than planned because you think you might avoid a downturn or catch a rebound. Once you go down that road, you might as well scrap the notion of a diversified portfolio and join the ranks of the market timers.
Walter Updegrave is a senior editor at MONEY Magazine and is the author of "Investing for the Financially Challenged." He can be seen regularly Monday mornings at 8:40 am on CNNfn.
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