The investment industry's advice that most resembles the parental refrain of "Eat your vegetables!" is "Rebalance your portfolio!" Perhaps you remember hearing the phrase during your company's annual retirement-plan workshop. The words hit your ears right before you nodded off into a deep sleep.
It sounds boring, confusing, even unimportant — at best one more chore to tackle one day / someday. No wonder so few people ever get around to it. But you really should get around to it, preferably once a year. Here's why and how.
Why to rebalance your portfolio
You're a smart investor. You understand the importance of asset allocation, the purposeful dividing of your investment dollars across broad asset classes such as stocks and bonds. If you're following SMI's Fund Upgrading strategy, you've gone further, spreading your money across our five stock-fund risk categories and, if relevant for your situation, our bond-fund risk categories. You've done this as we guided you, based on your risk tolerance and season of life.
But how these allocations look in your portfolio today is probably quite different from how they looked 12 months ago. Because of the market's overall performance and each individual risk category's performance, you now have more money in places that did well and less in places that did not do so well. Rebalancing is all about bringing those allocations back to where they started.
If you find it counter-intuitive or even painful to sell some of your holdings that have done well, that's understandable. But rebalancing is about risk management. If the allocations you started the year with were right for you then, they are probably right for you now. Plus, think of it this way: Rebalancing is the epitome of selling high and buying low; you trim some holdings that have risen in value and buy shares of funds that have declined in value.
How to rebalance your portfolio
Annual rebalancing doesn't have to be done in January, but the start of a new year feels like an appropriate time to do so. While the process will look different for different people, depending on the makeup of their portfolios, here are the major steps.
- Step One
Add up the value of your investment portfolio (it'll help if you use a spreadsheet program such as Excel). We generally recommend that you define your portfolio as the sum of all of your investment accounts such as IRAs and 401(k)s. But there are some exceptions. For example, do not include any funds you are managing with the SMI Dynamic Asset Allocation strategy. That strategy does not utilize a traditional approach to asset allocation. It may call for you to be completely out of stocks or bonds at certain periods of time, so the traditional rules of rebalancing don't apply.
Other money to not count in this step includes your emergency fund and 529-plan college savings. Your emergency fund should be in a bank savings account. As for a 529-plan account, this money is likely to be invested in an age-based portfolio that is automatically rebalanced.
- Step Two
Determine how much of your investment portfolio is now in stock funds and how much is in bond funds — both the dollar amount and the percentage of the total portfolio.
- Step Three
Revisit your ideal asset allocation. Even if you know what it is, it may be worth your time to go through the brief Start Here section on our website again. With the passing of another year, perhaps you're now in a different season of life, or maybe your risk tolerance has changed since the last time you went through this exercise.
Let's say your ideal allocation is 80% stock funds and 20% bond funds. Create a spreadsheet, similar to the one in the table, applying this ideal allocation to your portfolio along with your current actual allocation. (This example shows the detailed risk category allocations used by SMI's Upgrading strategy in 2014. If you're using Just-the-Basics, you would show how your ideal and current allocations look across that strategy's four funds.)
- Step Four
Bring your current allocations in line with the ideal. In our example, that means selling some stock-fund shares and using the proceeds to buy more bond-fund shares.
Now you'll need to decide which specific holding(s) to sell. In the example, you can see that stock-risk category 3 (small/value) has done especially well, which has brought its current allocation (21%) well above the ideal (14%). This would be a place to consider selling some shares.
The other factor you'll need to weigh, though, is the cost of selling shares of a particular fund. Perhaps it's a transaction fee fund or you'd incur a short-term trading fee for selling. It may especially not make sense to sell shares in a taxable account since that would generate a capital-gains tax liability.
As you can see, rebalancing is part science and part art. Don't get overly caught up in trying to make the allocations across risk categories perfect. Start with the big picture of getting your stock/bond allocation in proper proportions. Then tweak from there, watching out for any fees that would make a specific change not worth the cost.