(This article previously appeared on RealDealRetirement.com.)
Between now and the end of the year, you’ll hear lots of pundits and investment advisers urge you to rebalance your portfolio. But is this almost universally recommended investment ritual really worth the time and effort?
The answer is yes, generally, but not for the reason you may think.
Why You Need to Rebalance
Rebalancing is simply a strategy for restoring your portfolio to the mix of stocks and bonds that jibes with your risk tolerance and financial goals. If all investments moved in synch, there would be no need to do this. But that’s obviously not the case.
Different parts of your portfolio almost always generate different returns, which means whatever asset blend you originally set will get knocked out of whack.
For example, let’s assume that at the end of 2007, you had 80 percent of your portfolio invested in stocks and 20 percent in bonds. The next year, 2008, the Standard & Poor’s 500 index got clobbered with a 37 percent loss, while the broad bond market gained a bit over 5 percent. So if you did nothing but reinvest interest, dividends and any other distributions, by the end of 2008 your 80/20 blend would have morphed to roughly 70/30, a considerably more conservative mix.
To return your portfolio to its original 80/20 proportions — and get you back to the more aggressive investing strategy that matches your risk tolerance and goals — you would rebalance.
In this case, you would sell enough bonds to bring them back down to 20 percent of your portfolio’s value and funnel the proceeds into stocks, pushing equities back to their 80 percent share.
When Rebalancing Isn't Necessary
But the case for rebalancing isn’t always so clear cut, which is why I said it’s “generally” worth the effort.
In 2011, for example, stocks gained a bit more than 2 percent, while bonds gained just under 8 percent. So a portfolio that started the year with an 80/20 stocks/bonds mix would have ended with…79 percent stocks and 21 percent bonds. Purists may disagree, but I’d say the two portfolios are effectively the same.
Rebalancing could even be counterproductive in such a case, since transaction costs and (if you’re dealing with taxable accounts) taxes could outweigh any benefit. Besides, when a portfolio’s proportions are off by such a small margin, you may be able to bring them back in line by adding new money to the lagging investments over the course of the year, rather than selling assets.
Even when rebalancing does make sense, it’s important that investors understand the benefit for doing it.
(MORE: Is a Robo-Adviser Right for You?)
You can easily get the impression that rebalancing leads to higher returns. Go to the rebalancing section of FutureAdvisor’s Investing Academy and you’ll see an example of how you would have ended up with an extra $30,000 by rebalancing a $100,000, 70/30 portfolio from the end of 1992 through 2009.
But it doesn’t always work out that way. If stocks outperform bonds pretty consistently over a stretch of years, you would end up with more money by not rebalancing.
For example, if you’d started 2009 with a $100,000 portfolio 70 percent in stocks and 30 percent in bonds, by the end of last year you would have had roughly $4,100 more had you just let your portfolio grow rather than if you had rebalanced back to 70-30 at the end of every year.
Or, to put it another way, you rebalance so you don’t end up with a portfolio that’s too aggressive when stocks are on a roll or too conservative when stocks have lagged or crashed. That’s important because you don’t want to go into a market meltdown with too much in stocks and end up bailing on equities at the market bottom — or have less than you should in stocks after a crash and miss out on the gains when stocks rebound.
When to Rebalance
There’s lots of debate about how often to rebalance — once a year, quarterly, monthly, only when the stock or bond portion of your portfolio grows beyond its ideal allocation by a certain margin. You can make a case for any of them, but I think annual rebalancing makes the most sense.
Few people have the discipline to stick to a more frequent schedule. On the other hand, if your 401(k), IRA or other investment account offers automatic rebalancing more frequently — or rebalances when an asset’s weighting moves above or below a certain threshold — you might as well take advantage of it. The most important thing is that you don’t let your portfolio get too lopsided.
You should also try to do as much of your rebalancing as possible within tax-advantaged accounts to avoid triggering taxes on any sales. And to the extent you can combine rebalancing with any tax-related moves, such as selling off shares of poor performers to generate realized capital losses that can be applied against realized capital gains or even ordinary income, so much the better.
Bottom line: periodic rebalancing is generally a good idea, provided you do it for the right reasons and only when your portfolio really needs it.
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