Make changes to your asset-allocation mix only on an as-needed basis.
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By Christine Benz | 10-20-11 | 06:00 AM | Email Article

Question: How should I decide whether it's time to rebalance? Should I be rebalancing every year?

Answer: Investors often wrestle with whether to take a strategic (that is, buy-and-hold) or tactical (active and hands-on) approach to asset allocation. Regular readers know that I generally favor the strategic approach, and I outlined some specific guidelines in this article. But rebalancing--the process of putting your portfolio's asset allocations back in line with your strategic targets--is a disciplined way to add a tactical element to a buy-and-hold asset-allocation strategy. Rebalancing helps ensure that you peel money away from your winners and add to your losers, and it's one of the best ways to enhance your portfolio's return and improve its risk level.

Christine Benz is Morningstar's director of personal finance and author of 30-Minute Money Solutions: A Step-by-Step Guide to Managing Your Finances and the Morningstar Guide to Mutual Funds: 5-Star Strategies for Success. Follow Christine on Twitter: @christine_benz and on Facebook.

But even investors who are sold on the merits of rebalancing often struggle with how often to do it. David Swensen, the manager of Yale's endowment, has argued in favor of frequent, even daily, rebalancing. That approach doesn't translate to the world of retail investors, however. Individual investors may have to pay taxes and transaction costs to rebalance, and such a rigorous rebalancing program would take up a ridiculous amount of time, too.

Some investors and advisors rebalance on a set schedule based on the calendar--every December, for example. The big advantage of rebalancing at year-end is that it enables you to be systematic about netting tax losses and gains versus one another in an effort to reduce your investment-related taxes.

The downside of rebalancing on a set calendar-year schedule, however, is that you may incur tax and transaction costs just to alter your asset mix by a few percentage points. For that reason, I favor a hybrid approach to rebalancing. Plan to conduct a thorough portfolio checkup every year, ideally at year-end. But rebalance only when your stakes in stocks, bonds, or cash are 5 or 10 percentage points out of whack with your target ranges. At the same time you rebalance to bring your stock/bond/cash mix back in line with your targets, you can also address any dramatic investment-style shifts that have occurred in your portfolio--for example, if growth stocks or funds are crowding out the value-oriented stocks in your portfolio.

If you've created an Investment Policy Statement--and I think that's a worthwhile starting point for every investment plan--that's a good place to articulate your rebalancing policy. Say, for example, you've decided to rebalance only when your stock/bond/cash weightings drift 5 percentage points above or below your targets. If your asset-allocation target for your retirement portfolio is 55% stock, 40% bonds, and 5% cash, you'd set out the ranges as follows:

  • Stocks: 50% to 60%
  • Bonds: 35% to 45%
  • Cash: 0% to 10%

Whether you allow your portfolio's allocations to the core asset classes (stocks, bonds, and cash) to diverge 5 or 10 percentage points from their targets depends on your personality and your time horizon. If you're a laissez-faire investor and you have a long time horizon for your money, you can choose to take action only if your asset allocations swing 10 percentage points above or below your targets. But if you like to be more hands-on or you're already retired, it's fine to rebalance when your allocation to any one asset class is 5 percentage points above your range.

Some investment policy statements include sub-asset-class breakdowns, setting parameters for large-, mid-, and small-cap stock exposure; you can also break out U.S. and foreign stock exposure. There's nothing wrong with that, but you don't need to get too fancy. Setting your exposure to the broad asset classes and keeping your portfolio in line with those parameters is most important.

A version of this article originally ran on April 6, 2010.

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Morningstar - 2011/10/20 - How Often Should You Rebalance? - <a href="http://www.morningstar.com/articles/author/30-christine-benz.aspx">Christine Benz</a>
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