Rebalancing is the act of selling or buying assets to return to your desired allocation.
- Nobody has successfully predicted the market year in and year out.
- Over a short period of time, different assets will rise and fall at different paces.
- Over an extended period of time, assets with comparable risk will have comparable returns.
If that’s all we know about the stock market, a person with no experience can come to a few conclusions. Instead of owning one asset class, own all of them. If you have two assets with comparable risk, A and B, and asset A rose above average and asset B fell below average, A can be expected to return to average by having below average returns and B can be expected to return to average with above average returns. If you knew that an asset will have above average returns while another asset will have below average returns, wouldn’t it make sense to buy the under performing asset and sell the over performing asset or balance your portfolio?
One of the smartest investors of all time, William Bernstein completed some interesting studies on rebalancing.
Over 24, 28-year periods, he concluded that the longer you waited to rebalance the higher your returns were. However, the longer you went without rebalancing the higher the risk.
Ways to Rebalance
There are a few ways you can get your asset allocation back to match your goals and risk tolerance:
- Buy more of low performing asset with new funds
- Or, sell the high performing asset, and buy the low performing asset with the cash from the sale
Rebalancing Investments in a Tax-Sheltered Account
It doesn’t get an easier than rebalancing in tax-sheltered portfolios like 401K’s and IRA’s. Since there are no tax consequences, the best way to rebalance is all at once. Therefore, sell high and buy low to reach your desired asset allocation
Rebalancing Investments in a Taxable Account
A Simple Rebalancing Strategy
Rebalance to your desired asset allocation every 18 months. Rebalancing only works if it’s done constantly.
Why 18 months? Once you’re beyond 18 months, your dramatically increase your risk. For example, your 50% bond and 50% stock portfolio could look more like a 75% stock and 25% bond. The longer you go without rebalancing the more risk you let into your portfolio. Also, 18 months is long enough to avoid any short-term capital gains in a taxable account.
If you feel like you can take on the risk, go above 18 months. The key is to keep it consistent.
Does This Sound to Complicated?
If this whole article just went over your head, don’t worry there’s a solution. Invest with a target-retirement-fund and have the rebalancing done for you. There’s nothing wrong with paying a very small fee if it increases your chances of success. (It’s what I do)
When was the last time you rebalanced? If it was over 18 months, calculate your desired asset allocation and rebalance.
If you have rebalanced recently, mark on your calendar to rebalance 18 months from the last time you did. No need to think about it in the interim.
Below is a great video that explains the advantages and disadvantages of rebalancing, with Wall Street Journal Personal Finance Columnist Jason Zweig. One of the best writers of personal finance today. (He talks about younger Gen Y investors at about the 1:45 mark. )