The Best Way to Fix Your Investment Mix
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Q: I need to rebalance my portfolio. Is it best to adjust my investments all at once or a certain amount daily, weekly, or monthly? — Cheryl, Corona, Calif.
A: Rebalancing, which refers to periodically resetting your mix of stocks, bonds, and other assets to your desired levels, is key to successful investing over the long run.
Not only does it force you to lighten up on the parts of your portfolio that have seen the biggest gains recently — and therefore tend to have more risk — it forces you to stay true to your plan (i.e. asset allocation).
But as with most things, there can be too much of a good thing. Most investors should plan to rebalance their portfolios about once a year and, in most cases, no more than twice annually.
“Rebalancing means you have a transaction, and a transaction inherently involves costs,” says Bob Phillips, a chartered financial analyst and managing principal at Spectrum Management Group in Indianapolis, Ind. If you are rebalancing in a taxable account, there are transaction-related expenses, such as trading commissions or mutual fund loads.
There are also tax-related expenses to account for, which can be a real drag on returns. If you rebalanced daily, weekly or even monthly, says Phillips, “the tax recording would be ungodly and the cost of having your tax return prepared with all those transactions might be more than what you gained from rebalancing.”
In fact, in a study published by the CFA Institute, the researchers found that for most investors the best strategy was to do it all at once, generally once a year and only if your asset allocation is more than 5% out of whack.
“So if your target allocation is 60% stocks and 40% bonds, you would not rebalance if your stocks grew to 63% of the portfolio and bonds fell to 37%,” says Phillips, noting that the researchers ran thousands of scenarios to come to this conclusion. (In this case, you would only want to rebalance after your equity allocation drifted to more than 65% or less than 55%.)
In the case of a 401(k) plan or other retirement account, you can afford to rebalance more frequently. But even then, it’s best to do so in moderation.
After all, if you were rebalancing daily in a rising market, you'd be constantly selling investments before they've had much room to run.
Keep in mind that rebalancing need not require selling your pricier assets.
One way to keep things in balance in your 401(k) without incurring transaction fees and tax headaches is to simply tweak how you invest your new contributions (assuming you are still contributing).
For instance, say you want a 60% stock/40% bond allocation, but by year end you notice that it has drifted to 65% equities. Here, you would leave your already accumulated assets alone. But you would put most of your new 401(k) contributions into bonds until your accumulated balance shifts closer to that desired 60/40 mix.