Rebalance Your Portfolio
Rebalancing is different from reallocation.
Rebalancing is adjusting your portfolio through time to keep it in sync
with your risk level. For example, say you're a moderately aggressive investor
with an asset allocation of 80% stocks, 15% bonds and 5% cash. If the performance
of your investments pushed that mix to 90% stocks and 5% bonds, you might
sell some stocks and buy some bonds to bring those percentages back in
line.
Reallocation is shifting to a new
asset allocation plan that reflects an entirely different risk level. For
example, an investor in her 30s may prefer an aggressive asset allocation
with 95% stocks. But by the time she retires, she may switch to a moderately
conservative approach with only 40% stocks.
Why rebalance?
Creating an asset
allocation and investment plan
and then rebalancing is a little like planting a garden. Planting the seeds
may be the first step, but without some important care along the way (watering,
pruning) the desired results may not come to fruition.
In rising stock markets, people often
take on more risk than they're suited for. We saw this in the last market
cycle. In the late ‘90s, many investors fell in love with stocks and didn’t
rebalance, so they ended up with a much larger percentage of stocks in
their portfolios than their risk levels warranted.
Many times, people only realize they've
taken on too much risk when they experience the negative effects of that
risk—when the market goes down. Many investors bought all the way up, and
when the market started to crack, they realized they'd taken on too much
risk and sold on the way down—the reverse of the old “buy low, sell high”
mantra.
For example,
let's assume your initial allocation of $50,000 exactly a year ago was
70% in stocks, 20% in bonds and 10% in cash.
The following
table shows that stocks earned a 10% rate of return for the year, while
bonds earned a 7.5% return and cash earned a 5.5% return. Based on these
returns, and assuming no reinvestment of dividends or interest, your portfolio's
current value is $54,525.
To calculate
the weighted-average rate of return for the portfolio, multiply the return
for each asset class by its original weighting. Then add the returns. In
this case, the weighted-average return is 9.1%: (.10 x 5.5)+(.20 x 7.5)+(.70
x 10.0). You can check this by calculating the percentage change in the
portfolio value: ($54,525 - $50,000) / $50,000 = 9.1%.
| |
Initial
Allocation |
Original
Weighting |
1-Year
Rate
of
Return |
Current
Value |
Current
Weighting |
| Cash |
$5,000 |
10% |
5.5% |
$5,275 |
9.7% |
| Bonds |
$10,000 |
20% |
7.5% |
$10,750 |
19.7% |
| Stocks |
$35,000 |
70% |
10.00% |
$38,500 |
70.6% |
| Totals |
$50,000 |
100% |
9.1% |
$54,525 |
100% |
|
The portfolio's
current weighting is only slightly different from its original weighting:
Stocks now make up 70.6% of the portfolio value, while bonds comprise 19.7%
and cash comprises 9.7%.
Since your
allocation has only slightly changed, you may not need to rebalance. But
consider another example. You start with the same $50,000 portfolio and
the same allocation. In this case, stocks earn a 20% rate of return over
the next year, while bonds and cash each earn a 5% return:
| |
Initial
Allocation |
Original
Weighting |
1-Year
Rate
of
Return |
Current
Value |
Current
Weighting |
| Cash |
$5,000 |
10% |
5% |
$5,250 |
9.1% |
| Bonds |
$10,000 |
20% |
5% |
$10,500 |
18.2% |
| Stocks |
$35,000 |
70% |
20% |
$42,000 |
72.7% |
| Totals |
$50,000 |
100% |
15.5% |
$57,750 |
100% |
|
The weighted-average
return has risen to 15.5%. Notice the change in weightings -- Stocks now
make up 72.7% of the portfolio. You may decide to rebalance to the initial
allocation, which would require shifting 2.7% of the current value of stocks
-- or $1,575 -- into bonds and cash:
| |
Before
Rebalancing |
Dollar
Rebalancing |
After
Rebalancing |
New
Weighting |
| Cash |
$5,250 |
$525 |
$5,775 |
10% |
| Bonds |
$10,500 |
$1,050 |
$11,550 |
20% |
| Stocks |
$42,000 |
($1,575) |
$40,425 |
70% |
| Totals |
$57,750 |
$0 |
$57,750 |
100% |
|
As in this
case, rebalancing is often an exercise in fine-tuning your current allocation.
No drastic revisions should be necessary if you've set up your
initial
allocation properly. Even with single-year returns of 20% for stocks, which
the previous case assumed, the amount to rebalance was only $1,575 for
a portfolio worth almost $58,000.
How often should you rebalance?
You should take a look at your portfolio
at least once a year, and think about pruning any asset class that's overgrown
its target by more than 5%.
Some major reasons to rebalance
include:
-
A change in your investment
profile. Your investment profile is a composite sketch made up of your
financial goals, risk tolerance and investment horizon. Your investment
profile changes if any of these elements change. Typically, investors increase
their allocations to cash and bonds as they get older.
-
Changes in relative investment performance
of assets. Although stocks outperform bonds over the long term, there are
periods where bonds outperform stocks.
-
A major life
event. Major life events such as the birth of a child or unexpected
medical expenses will likely lead you to change your investment profile.
As a result, your asset allocation needs may change.
-
Failure to reach financial goals. You
may need to rebalance in favor of aggressive-growth or growth stocks if
you fall short of your financial goals. There are many reasons for falling
short, including overly optimistic expected returns, unanticipated inflation
or a change in your savings contributions.
|
