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By Jason Stipp | 10-19-2011 02:30 PM

Mechanics of Rebalancing

Strategic investors should keep both their most recent and their impending allocation targets in mind when rebalancing their portfolios, says Morningstar's Christine Benz.

Jason Stipp: I'm Jason Stipp for Morningstar. As part of Morningstar's 5 Days to Better Investing, today, we're talking about getting your timing right--specifically, getting your timing right with portfolio allocation and rebalancing. Here with me to discuss this is Morningstar's Christine Benz, director of personal finance.

Thanks for joining me, Christine.

Christine Benz: Jason, great to be here.

Stipp: So we talked about this week, how to set an allocation. How to find what could be a good starting point baseline for you, and some of the resources to do that. But then, ongoing, you do have to monitor that portfolio, and sometimes that involves rebalancing. So, I just want to quickly get a sense from you, what does that rebalancing entail? How often should you do it and when do you know that action needs to be taken?

Benz: Well, you can really rebalance on two schedules. One is on a calendar-year schedule--a lot of people like to rebalance at year-end, because it gives them the opportunity to try to find tax losses that they can use to offset gains in their portfolios. So, there's the scheduled calendar-year basis.

Or the way I prefer, actually, is to rebalance only when you see divergences of say 5 or 10 percentage points versus your asset class, asset allocation targets. The advantage of waiting until you see sizable divergences is that you can reduce your overall tax and transaction costs; you're not having to trade too much. You're making changes only when they're truly warranted.

Stipp: So ... we set those targets. We let those investments go, and we continue to invest in that allocation, and then you bring those back to those targets.

But we do know also over time, as you get older, as you reach that retirement age or that goal for your money, that the targets will change. So, you might start out with a lot of stocks, but eventually, when you're in retirement, you don't want to have all those stocks. How does that change happen? How do you know what's the pace of this overall change in my portfolio composition that's going to need to take place?

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