Q: Is there a preferred way to rebalance a portfolio? My bond funds need an infusion. It seems like it might be good to harvest some of those stock increases by moving money from equity funds to bond funds.
A: Rebalancing a portfolio is a simple but effective money management technique.
The essence of investing is uncertainty. For example, I’m an optimist on equities and the economy. I think the market gains are largely powered by healthy corporate profits, as well as technological and organizational innovations, gains that will eventually show up in healthier economic growth.
Pessimists argue the stock market’s surge mostly reflects the Federal Reserve’s easy money policy. The market will crater when the Fed decides it’s time to reverse course.
Of course, no one knows what markets will sizzle and what assets will fizzle by year-end, let alone 10 years or 30 years from now. That’s why I favor investment strategies that don’t rely on forecasts. Among those strategies is asset allocation and rebalancing.
The essence of asset allocation is the trade-off between risk and expected return. Stocks offer the highest potential return but also the greatest risk, typically defined as volatility. U.S. Treasury bills are basically a no-risk investment. The price for security is a low return. Focus on divvying up your long-term savings between stocks, bonds, and cash (the three main assets for portfolios), adjusted to your capacity to absorb risk and your own personal time horizon — when you’ll need the money. You stack the odds in your favor by concentrating on what you can control.
Let’s say you have a target asset allocation of 50 percent stocks, 30 percent cash and 20 percent bonds. Over the year your portfolio values shift to, say, 75 percent stocks, 15 percent bonds and 10 percent cash. Do you accept the market’s judgment or do you rebalance your portfolio to get back to your original risk profile? The standard advice is to rebalance whenever the portfolio gets 7 to 10 percent away from your asset allocation. By systematically rebalancing, you’re forcing yourself to buy low and sell high.
I wouldn’t balance too often. Jason Zweig, the smart investing columnist at the Wall Street Journal, ran several rebalancing scenarios, some very active. He concluded once a year is plenty. “Pick a date that will never vary and that you will always remember, like your birthday,” he recommends. A certified financial planner I know reviews her portfolio on New Year’s Day.
Assuming a long-term portfolio such as a 401(k) or 403(b), I favor harvesting the portfolio all at once. Get your asset allocation to where you want it to be fast. You can also make any additional adjustments at the same time. For example, many people learned over the past five years they were too aggressive or too conservative. In that case, the rebalancing moment is also a savvy time to overhaul your portfolio decisions.
The harvest-now approach works with tax-deferred retirement accounts. You don’t have to worry about Uncle Sam’s levy when rebalancing a 401(k). If you want to adjust a taxable portfolio you’ll definitely need to take capital gains taxes into account. The strategy in this case is to shift the portfolio with new money rather than paying taxes (assuming you like your current investments).