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6 rules for rebalancing your portfolio

August 26, 2008

It's vital to revisit and monitor your portfolio at least annually to check on the status of your allocations and make sure your investment funds are performing as expected. Why?

Here's the rebalancing 'problem' in a nutshell.  Let's assume you're an investor with a portfolio that includes $100,000 in stock funds (50 per cent of the portfolio) and $100,000 in bond funds (the other 50 per cent).  For simplicity's sake, let's say the stocks have doubled in value to $200,000. 

Note, however, that your portfolio's asset allocations are now 67 per cent in stocks and 33 per cent in bonds, a 17 per cent deviation from your original portfolio.

Depending upon your stage in life and your financial plan, this happy development may mean it is time to rebalance.

When is it time to rebalance your portfolio?

  • Long-term investors should only rebalance when truly necessary, for example
  • When significant gains (such as those from the bull market) or major losses have skewed your intended allocations;
  • When your investment objectives change;
  • When you need to shift your portfolio into more fixed income vehicles (bonds) as you enter retirement or plan to invest part of your savings for a shorter-term need;
  • When stock or fund seems to be consistently and continually slipping compared with the benchmarks; or
  • In the case of a mutual fund, when a proven manager leaves a fund and you are unsure about the replacement.

Research shows us that rebalancing too often accomplishes very little, except in extreme cases.  In other words, take the time to choose your allocations correctly and stick with them: Rebalance annually and sell only the bottom quartile of your holdings based on performance.

Monitoring your investments is an important part of portfolio maintenance, but remember that buy-and-hold investors are long-term strategists. Life has a strange and unpredictable habit of forcing us to rebalance our lives as well as our portfolios unexpectedly. Rebalancing is as natural as replacing an automobile or anything else that wears out or just falls apart.

Always remember that the object of rebalancing your investments is to focus first on your overall portfolio, not so much on individual stocks, funds or fixed income securities.

6 portfolio rebalancing rules

Here are six crucial rebalancing rules, according to the American Association of Individual Investors Journal.

Annual rebalancing: "Remember that rebalancing does not need to be frequent - annually is sufficient.  However, your actual portfolio allocations will be constantly changing due to varying performances and as you withdraw funds."

Don't stray too much: "Don't worry about straying from your desired allocation by a few percentage points, but straying by 5 per cent should start to become a concern, and straying 10 per cent will have a major impact on your portfolio's return. In between that range - it's a tough decision and will likely be dictated by your personal tax situation and personal preferences."

Minimum commitments: "At least 10 per cent of a portfolio must be committed to a market segment to have a meaningful impact" on your portfolio.  "If your desired allocation to a particular asset class is only 10 perc ent, you would not want to stray below that amount by very much; in contrast, falling a few percentage points below a 30 percent desired level would be less of a concern."

Discipline: "Rebalancing provides a discipline: it forces you to sell high and buy low." In other words, when making specific rebalancing decisions, a savvy investor will take profits in the sales, while seeking value in the replacements.

Don't get greedy: If you have a portfolio of mutual funds that have been very successful, "consider selective pruning of individual holdings that have done well." In short, stay focused on your overall portfolio, without failing in love with any particularly hot funds.

Focus on the long term: "Enjoy the bull market while it lasts, but don't let several terrific years deflect you from a long-term strategy." In short, remember: The market does advance, but in cycles that go down as well as up.  Plan your asset allocations for the long term through both phases.

(Excerpt from The Winning Portolio: How to Choose the Best Mutual Funds by Paul Farrell, published by Vision Books)

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