Rules For Rebalancing It's November 2002. When did you last adjust your asset allocations?
(MONEY Magazine) – It's the most underrated component of portfolio management. It's blindingly simple yet devastatingly effective. And it's something that--unfortunately--very few investors actually do. No, we're not unveiling a little-known stock-picking tool or an arcane hedge fund strategy. We're talking about the tried-and-true principle of rebalancing your portfolio--regularly adjusting allocations to keep your asset mix on track. That may sound familiar, but ask yourself this: When was the last time you rebalanced? First, of course, you need an allocation plan. If you haven't set one up, consult the model portfolios on page 99. Or click on Personal Finance at our website, www.money.com, for an easy-to-use asset-allocation tool. But don't stop there. "Many investors take the trouble of developing the right asset allocation, but they fail to rebalance," says Scott Lummer, an investment consultant in Santa Rosa, Calif. "As a result, they throw away the benefits of their asset-allocation plan." With stocks down an average of 30% this year alone and bonds up more than 7%, chances are your portfolio is out of whack--so get going. Remember, in your retirement accounts there are no tax penalties and few costs if you shift assets. And in your taxable accounts, you can probably take losses to offset any capital-gains taxes due. You already know this, but it's worth repeating: The biggest benefit of rebalancing is that it reduces your risk of steep losses. Consider a recent study by fund group Morningstar that compared the results of investing $10,000 in a stock/bond fund portfolio that was regularly rebalanced and an identical portfolio that was not rebalanced over 10 years ending last June. Analyzing the two portfolios' 12-month rolling returns, Morningstar found that at its peak the portfolio that was never rebalanced--we'll call it portfolio A--reached $31,887; portfolio B, which was rebalanced quarterly, fell short, at $30,619. But as of June, portfolio A had fallen to $25,016, a loss of 21.6%, while portfolio B slipped only 17.6%, to $25,234. Over the whole 10 years, the final returns varied very little, but an investor in the rebalanced portfolio would have had a much smoother ride. Despite the advantages of rebalancing, most investors just don't do it. A survey by benefits firm Hewitt Associates found that nearly 80% of 401(k) participants failed to make a single change in their plans in 2001. As a result, the average 401(k) equity allocation has fallen from a peak of 74% of assets in 2000 to just 57% this year, chiefly because of stock price declines. "[The few] who have changed their accounts," says Lori Lucas, a consultant at Hewitt, "are mainly chasing the best-performing assets, fixed-income funds, which means they are making exactly the wrong move." Why is rebalancing so hard for investors to get right? For one thing, it takes guts. "With rebalancing you have to be a contrarian--you are selling your winning investments and putting your money in losers," says William Bernstein, an investment adviser in Coos Bay, Ore. "For most people, that's extraordinarily difficult psychologically--they just can't do it." And rebalancing was a particularly hard sell in the late '90s, when investors who rebalanced earned less than those who rode the tech and large-growth stock bubble. But today's volatile markets make rebalancing more critical than ever. We discuss several strategies below, first for tax-deferred accounts and then for taxable ones; tools available to help you keep your mix on track, including funds that manage the rebalancing for you; and, on page 100, 15 funds that can help you fill out your asset mix. OPTIONS FOR TAX-DEFERRED ACCOUNTS Rebalancing is a simple concept: Say you have chosen a 60% allocation to stocks and 40% to bonds. You discover that market moves have reduced your equity stake to 55% of assets, while bonds are up to 45%. You then shift enough money from bonds to stocks to restore your target allocation. That said, there are different approaches to rebalancing; they boil down to timing and trigger points. CALENDAR REBALANCING. Choose a particular date or dates, such as the end of the quarter, your birthday, or perhaps when you receive your annual statements. On that day, compare your allocations to your targets. If they're off by five percentage points or so, rebalance. (Some advisers set the allowable range at 10 percentage points, but no more.) Your 401(k) plan may allow you to switch money daily or weekly, but avoid that temptation--quarterly should be the max. "The risk for investors is that they may end up overreacting to the market," says Lucas. During periods of modest volatility, you may need to rebalance only every few years. PRO: Calendar rebalancing is as simple as it gets, which means you are more likely to follow through. CON: You may have to sit through periods of extreme volatility before your rebalancing date arrives. BEST FOR: Investors who want to stick to their goals with the least amount of effort TARGETED REBALANCING. This involves more frequent monitoring of your portfolio, perhaps even monthly. If your allocations have moved outside of your target range by five to 10 percentage points, rebalance immediately. PRO: You minimize volatility and stay more closely aligned with your allocations. CON: You need to stay on top of your portfolio and may incur higher trading costs or make unnecessary shifts. BEST FOR: Active investors who wish to minimize risk TACTICAL REBALANCING. A more controversial approach, this requires setting target ranges rather than specific targets--for example, you might peg your large-cap stocks at 35% to 50%. Then, depending on your outlook for the market, you might let your allocation hover at the upper or lower end of that spectrum. Right now, for example, Louis Morrell, vice president of investments at Wake Forest University, is keeping the endowment's allocation at the lower end for domestic stocks and the upper end for foreign stocks, where he sees more opportunities for growth. PRO: Staying light on losing sectors is more comfortable. CON: Can you outguess the market over the long term? BEST FOR: Active investors with strong market convictions STRATEGIES FOR TAXABLE ACCOUNTS Outside of tax-deferred accounts, different rebalancing rules apply. Generally, it's best to direct new contributions into the underweighted asset classes--rather than shifting money from one to another--so you won't incur unnecessary capital-gains taxes or trading costs. But if your portfolio is so out of balance that it might take you more than two years of additional saving to get back to your target, or if you are really worried about the risk of your imbalance, then it makes sense to shift the money directly--especially now, when you can probably take losses on some of your equity accounts. TACTICS AND TOOLS Surprisingly, only a few defined-contribution plans offer an automatic rebalancing service, but if your money is stashed in a single tax-deferred portfolio such as a 401(k) or 403(b) account, rebalancing is relatively convenient. Most plans permit you to check your balance online, and many provide a tool that allows you to enter target percentages, then click to bring your portfolio into line. Or you can call a customer rep, who can rebalance your portfolio for you. If you have more than one portfolio, it's a bit trickier. After all, you don't want to put too much 401(k) money into small-caps if your IRA or taxable account is already loaded up with small fry. Financial software such as Quicken and websites like Morningstar.com can help you determine if you're overweighted or underweighted in a particular asset class. Your fund company or broker may also offer rebalancing services. T. Rowe Price will adjust allocations on a quarterly basis for its IRA investors. And at Schwab's website you can track multiple portfolios, including outside accounts. For painless rebalancing, it's hard to beat a lifestyle fund such as Vanguard LifeStrategy Growth (800-851-4999)--a fund-of-funds portfolio, available to both 401(k) and retail investors. This low-maintenance approach is a particularly sensible choice for a 401(k), where you can easily shift your money if you later decide to build your own portfolio or change your asset mix. A lifestyle fund may also be a good option for a taxable account, since managers of these funds tend to direct cash inflows to underweighted assets rather than to trade. Remember, though, that lifestyle funds are meant to be all-in-one investments. A study by Hewitt found that many 401(k) participants hold such funds as one of several funds, which defeats that purpose. Many lifestyle funds maintain a static allocation, but some, known as life-cycle or life-stage funds, gradually shift from equities into bonds as a particular retirement date approaches. These life-cycle or life-stage funds are increasingly available in 401(k) plans and to retail investors. If you are a long-term investor who does not actively monitor your mix, one of them may be a good choice. But don't just pick a fund based on your estimated retirement date. Even if you plan to retire in 2010, you might prefer a 2030 fund, such as Fidelity Freedom 2020 (800-343-3548), that will still hold 50% in stocks in the year you turn 65. You also need to consider the asset classes represented in the fund--T. Rowe Price Retirement 2020 (800-638-5660), for example, has a hefty 21% in large-cap growth stocks, which may be too risky for you. Whatever approach you choose, you will need to keep tabs on your portfolio. Rebalancing is too important to your future to be left entirely in someone else's hands. |
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