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Course 505
Rebalancing Your Portfolio

Introduction

So you've built a portfolio that perfectly matches your needs. If only you could kick back and ignore it until retirement. In order to keep your portfolio in shape, you have to monitor it on a regular basis. You'll want to reevaluate all of your funds and make sure that you don't have a reason to sell any of them. You'll also want to make sure that your asset allocation hasn't become lopsided - and if it has, you'll want to rebalance your holdings. In this lesson, we'll examine why rebalancing matters and offer our suggestions for how and when you should rebalance your portfolio.

Why Rebalance?

Say that you originally constructed a portfolio of 60% stocks, 30% bonds, and 10% cash. If left alone over a 20-year period, that portfolio could easily morph into a blend of 84% stocks, 13% bonds, and 3% cash, just because some asset classes will grow faster than others. Presumably, you set up your original allocation to match your needs and your risk tolerance. If neither has changed--or if your asset-allocation parameters have actually gotten more conservative, as is usually the case as people get closer to retirement--your new allocation will be out of sync with your targets. If stocks dominate your portfolio (as they did in our example), your returns may rise but so will your risk. Moreover, you may find yourself with insufficient cash on hand to meet short-term needs. The only way to return the portfolio to the original stock/bond/cash mix is by buying and selling funds until you reach your original allocation. That's what rebalancing is.

Our Rebalancing Principles

If you ever watched the Ed Sullivan Show, you probably remember the plate-spinning act - the guy who kept all that fine china spinning precariously atop long, flexible rods. It was pretty impressive, all those place settings gyrating at once as the performer ran back and forth to give each rod a flick and keep it all from toppling down.

If you were to rebalance your portfolio frequently, you'd feel a lot like this guy. Relax. Rebalancing your portfolio doesn't have to be a juggling act if you follow our guidelines.

Don't rebalance too often.

You needn't worry about rebalancing every quarter, or even every year. Research from Vanguard has demonstrated that investors who rebalanced their investments when their asset-class exposures veered five percentage points from their targets reaped many of the same benefits as those who rebalanced more often. Moreover, investors who rebalance less frequently save themselves unnecessary labor and may even save a good bit of money, both in taxes and transaction costs. That's because rebalancing may trigger commissions to buy and sell. It also requires paring back the winners, which means realizing capital gains and, for the taxable investor, paying Uncle Sam. We're not saying you should tune out your portfolio unless there's been a big market movement; in fact, we think you should monitor your portfolio regularly to watch out for manager or strategy changes at your individual funds. But resist the urge to tinker unless one of your funds has significantly changed its strategy.

If you rebalance just one thing, make it the stock/bond/cash split.

Your cash and bond stakes are vital to keeping your portfolio's risk in check. Because bonds don't generally move in sync with your stock investments, a simple strategy of restoring your cash and bond funds to their original weightings once they veer five or 10 percentage points will dramatically lower your portfolio's overall risk.

Mind the drag of taxes when rebalancing.

Taxable investors take note: Concentrate your rebalancing efforts in your tax-sheltered accounts to avoid triggering taxable capital gains. (Even if you sell winners that you hold within your 401(k) and IRA and use the proceeds to bump up your weightings in laggard holdings in those same accounts, you won't pay capital gains taxes.) And if you must rebalance within your taxable account, consider doing so by adding new money to the asset classes and categories that have lagged rather than selling winning holdings. If you don't have new money to put to work, consider having your funds' income and capital-gains distributions paid into a money market account, then using that cash for rebalancing.

Quiz 505
There is only one correct answer to each question.

1 What is rebalancing?
a. Restoring your portfolio to its original risk level by buying and selling funds until you reach your original allocation.
b. Putting together a portfolio of mutual funds.
c. Allowing stocks to take up more of your portfolio.
2 What's a sensible way to determine whether rebalancing is in order?
a. Check to see if the market went up by 5% the day before.
b. Make changes every year no matter what.
c. Check your current allocations versus your targets. If your overall exposure to the major asset classes is five or more percentage points higher or lower than your targets, it's a good time to rebalance.
3 Which is the most important part of your portfolio to rebalance?
a. Your individual fund holdings.
b. Your subasset-class or investment-style breakdown--for example, your split between small- and large-cap stocks.
c. Your asset allocation of stocks, bonds, and cash.
4 Which way is not a tax-efficient way to restore balance to your portfolio?
a. Rebalance your taxable accounts by adding new money to your laggards.
b. Rebalance your taxable accounts by selling your winning holdings.
c. Concentrate your rebalancing efforts in tax-sheltered accounts like 401(k)s and IRAs.
5 What might cause the need to rebalance?
a. Market activity.
b. A change in your asset allocation parameters.
c. Both market activity and a change in your asset allocation parameters.
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