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Course 305
Rebalancing Your Portfolio

Introduction

You've probably never heard someone say, "I can see why you stick with that guy--he's a real loser!" Everyone prefers winners.

So if an investment is successful, naturally, you'd want to stick with it. The last thing you'd want to do is sell some of your winners to invest more money in your investments that aren't doing as well.

No matter how unnatural that practice seems, however, that process—called rebalancing--is an essential part of managing your investment portfolio.

Here's what rebalancing is, why it's important, and how to do it.

What Rebalancing Is

Rebalancing is the process of restoring your portfolio to your target allocation for it.

You don't have to do anything to your portfolio for it to change. That's because some of your investments will do particularly well while others won't. (That was the whole point of diversifying your portfolio in the first place, remember?) Those investments that have done well will naturally begin to take up more of your portfolio; those that haven't done as well will take up less of your portfolio. And you don't have to do a thing for that to happen.

But every so often, you need to readjust your portfolio, to restore its original balance. If your investment goal hasn't changed, your portfolio's mix shouldn't, either. Because of market forces, however, it does.

Why Bother?

Rebalancing is primarily about risk control, or making sure your portfolio isn't overly dependent on the success or failure of one investment, asset class, or style.

Let's say that you put $10,000 in T. Rowe Price New Income (PRCIX) and $10,000 in T. Rowe Price Growth Stock (PRGFX) in January 1997. At the end of 2006, you had to congratulate yourself. Your $20,000 investment had turned into more than $41,000.

Credit a lot of that success to the stock fund. Your position had grown to more than $24,000 at the end of the period. T. Rowe Price New Income, while no slouch itself, was just $17,271.As a result of that outperformance, T. Rowe Price Growth Stock soared to roughly 60%  of your portfolio in late 2006. You decide not to mess with its winning streak.

By late 2008, however, you would've gone from patting yourself on the back to kicking yourself you know where. Your portfolio lost more nearly 20% over the two previous years. The culprit? T. Rowe Price Growth Stock, which, like most stock funds, lost nearly two thirds of its value in that two-year period, a vicious bear market for stocks. T. Rowe Price New Income, on the other hand, made money during that period.

If you had rebalanced your portfolio at the beginning of 2007, re-establishing equal positions in the funds, you wouldn’t have lost half as much during that year. Rebalancing would have protected a sizable chunk of the gains you made with T. Rowe Price Growth Stock.

The upshot: No one investment style stays in favor forever. In the mid-1990s, for example, all investors cared about were financials stocks. Then from the late-1990s until March 2000, technology stocks were the "in" cocktail-party chatter. After that, the hot investments were REITs, or real-estate investment trusts. Bonds have been in vogue ever since the bear market of 2007-2009. In the bear market, nearly all stocks were hammered, but high-quality bonds held up just fine.

And that's the whole point of rebalancing: You don't know what asset class, sector or investing style is going to rule the investment world next year, or how rapidly things might change. Rebalancing helps you reap the full rewards of diversification. Trimming back on a winner allows you to buy a laggard, protect your gains, and position your portfolio to benefit from a change in the market's favorites.

How to Do It

Convinced? Good. Now comes the sticky part: figuring out just how to rebalance.

Rebalancing would be a cinch if all your money was in one account. But you may be investing for one goal via various vehicles. For instance, you may have some retirement assets in an IRA, more in an employer-sponsored retirement account, and even some in a taxable account.

If these accounts are all funding one goal, they are, for all intents and purposes, part of one portfolio. So when you rebalance, you're not just going to rebalance your employer-sponsored account. You should rebalance across all of these accounts simultaneously.

Here's how:

Step 1: Recall your target portfolio mix. 

You included the details of this mix in your Investment Policy Statement. (If you haven't developed your investment criteria or created your Investment Policy Statement, review Portfolio 108 and download Morningstar’s Investment Policy Statement Worksheet at http://news.morningstar.com/pdfs/Investment_Policy_Worksheet.pdf. (Note: The worksheet is available as a PDF file. You will need Adobe® Acrobat® Reader to view and print it.) This was the blend of asset classes and investment styles that were going to allow you to reach your investment goal.

Step 2: Compare your target mix to your current mix.

Consult your portfolio statements or online tracking tool. Morningstar.com can help with its Instant X-Ray and Portfolio Manager tools. Just enter a new portfolio or retrieve one you have already saved on Morningstar.com.

Step 3: Determine where your investments are out of whack.

Begin by seeing how your cash and bond positions have shifted relative to your stock stake. Very often, your positions in these areas will shrink relative to stocks because, in general, stocks as a group outperform cash and bonds.

 

Next, examine your style-box mix. Do you have a larger stake in small-company stocks than you did originally, for example? Or are growth stocks taking up more of your portfolio than they did before?

Then, consider your sector exposure. Although you may not have built your portfolio with a specific sector mix in mind, you want to be sure that you aren't overexposed to one particular industry.

Finally, look at your investments, one by one. Which ones have performed the best? These investments may now be taking up more of your portfolio than you originally intended.

Step 4: Readjust. 

Pare back the parts of your portfolio that have grown and direct those dollars to the investments that haven't.

Our Rebalancing Guidelines

Rebalancing may at first remind TV buffs of the plate-spinning act from the Ed Sullivan Show--the guy who kept all that fine china spinning precariously atop long, flexible rods. How stressful it must have been to keep all those place settings gyrating at once, running back and forth to give each rod a flick and keep it all from toppling down.

Effective rebalancing doesn't have to be nearly as tension filled. You don't need to keep daily tabs on your portfolio and tweak it weekly. Instead, consider these guidelines.

Guideline 1: Rebalance only on an as-needed basis.  We're not saying you shouldn't look at your portfolio periodically. But resist the urge to tinker. You’ll save yourself unnecessary labor and, if your portfolio includes taxable accounts, a good bit of money. That's because rebalancing requires paring back the winners, which means realizing capital gains and, for the taxable investor, paying Uncle Sam.

Some people like to rebalance on a calendar-year basis—say, every December. But a better strategy is to conduct a thorough checkup of your portfolio once a year, but rebalance only when your portfolio’s asset allocation is out of sync with your targets. For example, you might only rebalance when your portfolio’s allocations to stocks and bonds diverge from your target allocation by five percentage points. (On the Investment Policy Statement, you can specify ranges for your allocations to each asset class. For example, your target allocation to stocks may be 55%, but you’ll let the weighting go as high as 60% or as low as 50% before making changes.) Hands-off investors could give their portfolios an even longer leash, rebalancing only when their allocations to the major asset classes diverge by 10 percentage points relative to their targets. 

Guideline 2: If you rebalance just one thing, make it the stock/bond split. Your cash and bond stakes are vital to keeping your portfolio's risk in check. So if you don't want to take the time to rebalance your entire portfolio on a regular basis, at least restore your cash and/or bond positions when they’ve diverged widely from your targets.

Guideline 3: Be a tax tactician. Keeping your portfolio's volatility in line isn't satisfying if your rebalancing strategy means you also wind up with poor aftertax returns. Here are three things you can do to minimize taxes:

1. Use new money--say from a bonus or a gift--to restore your portfolio’s balance. Adding fresh dollars to the laggards in your portfolio, helps you avoid the tax consequences of selling the winners. 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.

2. If you need to scale back in certain types of investments that you own in both taxable and tax-deferred accounts, sell the securities in the tax-deferred accounts first. That way, you'll limit how much you'll pay in capital-gains taxes.

   
 

Quiz 305
There is only one correct answer to each question.

  1 Rebalancing often requires you to:
    a. Sell some of your losers
    b. Sell some of your winners
    c. Sell everything
  2 What's the primary reason to rebalance?
    a. To control your portfolio's volatility
    b. To improve your long-term returns
    c. To save on taxes
  3 Which statement is false?
    a. Rebalancing helps you reap the full rewards of diversification.
    b. Rebalancing often has tax consequences
    c. Rebalancing doesn't allow you to benefit from a change in the market's favorites
  4 You're investing for your retirement via a 401(k) plan and an IRA. How should you rebalance these accounts?
    a. Rebalance the 401(k) plan but don't worry about the IRA
    b. Rebalance the IRA but don't worry about the 401(k) plan
    c. Rebalance both simultaneously, because they make up one portfolio
  5 If you want to save on taxes:
    a. Rebalance frequently
    b. Use new money to rebalance
    c. Sell investments from taxable accounts before selling investments from tax-deferred accounts
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