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Investing Answers Building and Protecting Your Wealth through Education Publisher of The Next Banks That Could Fail

Ask the Expert: How Often Should I Rebalance My Portfolio?

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Question: "I've heard a lot of reminders since the beginning of the year to check up on my 401(k) and other retirement plans and rebalance them if they're not diversified correctly. How often do I need to rebalance my portfolio?" - Albert, Brownsville, TX
The Investing Answer: I'll be honest with you, Albert. As much as I enjoy finding the smartest tactics for investing my money, I have to say that rebalancing my 401(k) plan and my other investing accounts is among my least favorite things to do. But it's also one of the most important when it comes to investing. You can't just leave this one alone if you want to successfully preserve and grow your wealth.
Before I answer the question, I want to talk about what it means to rebalance your portfolio and why it's so important.
Let's assume that when you first set up your 401(k) plan or other investment plan, you talked to an advisor or a human resources rep or researched on your own to create just the right portfolio allocation for you -- one that has the perfect mix of investments that fit your own risk tolerance and age.
[Haven't had a chance to set up a portfolio plan? Look at some examples in The Lazy Man's Retirement Portfolio.]
Whether you did that years ago or just a few months ago, it's inevitable that some of your investments will grow in value while others decline. This is fine in the short term, but leaving this alone without rebalancing will throw your portfolio seriously out of whack and could hurt your overall returns over the long term.
For example, let's say your investment portfolio was originally made up of 50% stocks and 50% bonds. Over the years, let's say stocks did poorly and fell in value, while the bonds in your portfolio did well. Your portfolio would end up looking much different -- and you'd be left with a much different mix of 40% of your money in stocks and 60% in bonds.
So what's the problem with that? If you don't rebalance your portfolio and get it back to the right mix, you'll miss out when the stock market comes roaring back because you won't have as much of your money in stocks. And that could take a serious bite out of your returns if you missed out on enough of those opportunities over the long run.
It can go the other way, too. Let's again say you started with 50% stocks and 50% bonds. Then let's say stocks did very well over the years, growing in value while bonds fared poorly. If your portfolio warped into a mix of 55% of your money stocks and 45% in bonds and suddenly there was a stock market crash, you'd suffer heavier losses than you would have if you rebalanced back to the 50-50 mix because more of your money would be in stocks. Enough of those tragedies can hurt your long-term gains as well.
Put simply, when you rebalance, you are essentially reining in the assets that have overperformed and putting more of your money into assets that have underperformed. You're selling off expensive and potentially overvalued assets in favor of undervalued ones that could take off in the future. It's another way of buying low and selling high -- a winning formula.
So, how often should you rebalance?
While you'll often hear that you should rebalance once or twice a year (perhaps in January and July), that can be too much or even too little. Because markets are largely unpredictable, you could risk rebalancing at the wrong time or waiting until it's too late if you choose to rebalance at an arbitrary time of the year.
Instead, a smarter approach would be to follow a 5% rule -- simply keep an eye on your portfolio every quarter, or at the very least after huge market moves, and make sure your assets are within 5% of where they should be when you last planned your portfolio.
For example, if your portfolio started with 80% in stocks and they do so well over the next four months that your holdings change to 85% or more in stocks, it's time to rebalance. Or, if your stocks do poorly and your holdings change to 75% or less in stocks, it's time to rebalance. The idea is to not let your asset classes change more than 5% of where they're supposed to be. That will keep you on track.
Of course, there are always exceptions. Your "original" portfolio plan may become outdated every 10 years as you approach retirement -- what was right for you then may not be right for you now. For example, a 30-year-old may want more stocks (and therefore a more aggressive investment strategy) than a 40-year-old. And a 50-year-old may want more bonds (meaning less risk). So you may want to research or work with a trusted advisor and readjust your investment mix each decade to fit your age and risk tolerance. But after you've readjusted your plan, keep using that 5% rule and rebalance every time your portfolio needs it.
It's also important to remember that rebalancing works best within retirement accounts. Because rebalancing involves selling, it could trigger unwanted capital gains taxes if you rebalance investments outside of a retirement account. But if your investments are in a retirement plan (such as a 401(k), IRA or Roth IRA), you may rebalance as often as you'd like without triggering taxes.
One more tip: If you're invested in a 401(k) plan and rebalancing your portfolio sounds like too much of a hassle, consider simply investing in a target-date fund if your 401(k) provider offers them. Target-date funds are simply mutual funds that are set up to match your age and risk tolerance and automatically rebalance your investments as you approach retirement. Sound appealing? Learn more about target date funds in "These Super-Simple Funds Take The Work Out Of Retirement Investing."
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