How to Rebalance Your 401K or Other Investment Portfolios

by RJ

in Investing

Rebalancing is the act of selling or buying assets to return to your desired allocation.

Any smart investor, especially an indexer, will take any advantage of all opportunities. Rebalancing is a chance to slightly increase your returns over the long-term.Over time a small increase in return makes a large difference. Over 40 years, a $10,000 initial investment will turn into $452,593 with a 10% return. However, with a 10.5% return, a  $10,000 will yield $542,614! (Yes, I double-checked but that’s compound interest as it’s finest)

The Purpose of Rebalancing

If you knew which part of your portfolio would increase during the next year, investing would be easy. Just pick the asset class that will rise the most and sell everything else. However, the only accurate prediction you can make is you don’t know where the market is headed. With over 100 years of stock market history, we have come to a few conclusions:
  • 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?

The Best Way to Rebalance
I’m sorry to say, but there is no concrete rule for rebalancing. Rebalancing will decrease risk, but there is no guarantee that it will increase reward.

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:

  1. Buy more of low performing asset with new funds
  2. 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

If your investments are not in tax-sheltered funds there are a few differences in how to rebalance.First, there are tax consequences when rebalancing. Therefore, never rebalance more than once inside of a year. This will incur a short-term capital gain, which is taxed at a higher rate than long-term capital gains.Second, don’t sell the high performing asset. Instead, purchase more of the lower asset with outside funds.This can be accomplished in one of two ways. You can invest a lump sum of savings into the low performing asset. If that’s not a possibility, take the dividends and interest payments from the high performing asset and reinvest them into the low performing asset.

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)

Action

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.

Video

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. )

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Tagged as: investing, Saving

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