In a previous post, Investing is Boring, I said that once you pick your funds and set up automatic investments into those funds, all that is left to do is rebalance. But what exactly is rebalancing and how often should you rebalance?
What Is Rebalancing?
To begin, rebalancing is simply adjusting your holdings so that they match your initial plan. For example, assume your investment plan called for a mix of 60% stocks and 40% bonds. You invest a total of $10,000 into ABC Equity Fund and ABC Bond Fund. In order to allocate per your plan, you would invest $6,000 in ABC Equity and $4,000 in ABC Bond. This gives you your 60% stock/40% bond portfolio.
Over the next year, you have been adding to your investments and when year-end comes, you have a balance of $12,000 in your portfolio. More specifically, you have $8,000 in ABC Equity and $4,000 in ABC Bond. Your current allocation is 66% stock and 34% bond. Because the portfolio is no longer in line with your plan, you need to rebalance. To do so, you will sell 6% of the stock fund ($720) and buy $720 in the bond fund. This will get you back to your 60% stock/40% bond allocation.
How Often and When?
There are three times when the majority of investors rebalance: quarterly, semi-annually, or annually. I tend to rebalance my portfolio semi-annually, or every six months. The size of your portfolio and which investments you add additional money to also determines how often you should rebalance.
One more point about the act of rebalancing: there is no need to rebalance if your allocation is off by less than 5%. This is because it really is not worth the time or possible expenses incurred to rebalance. In the case above, you were off by 6%, so you rebalanced. If you were at 62% stocks/38% bonds, you would have left the portfolio alone.
- Look at your investments every six months for the opportunity to rebalance.
- If the percentages are off by 5% or more, rebalance. Otherwise, do nothing.
You may be asking me what the point of rebalancing is. To put it simply, rebalancing helps you to take your emotions out of investing. Many investors invest according to their emotions: they buy in when the market is rising and sell out when the market is dropping. This is the exact opposite of what you should do!
You should be buying low and selling high. Rebalancing allows you to do this. In our example above, stocks were rising so we sold out of them and bought into bonds, which weren’t rising. Without rebalancing, you allow your portfolio to deviate from your investment plan. If stocks rise higher, you will be overweight in them, causing you to take on more risk than you had planned. This could lead to larger losses than you are willing to take.
On the flip side, if bonds rise, you will be taking on less risk than you intended. While this sounds good, with less risk comes less return. The lower return may force you to cut back your plans for retirement because you don’t have enough money. Either case is not good.
Make it a habit to review your portfolio twice a year so that you can achieve the results you had outlined in your investment plan.
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Hi, my name is Jon and I run Penny Thots. I’ve been interested in personal finance since high school and love writing and talking about it. You can learn more about me in the Authors section of this site.