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Mechanics of Rebalancing

Jason Stipp

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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Benz: That's a great point, Jason, and I don't think it's often discussed in the context of rebalancing, but that definitely should be part of your rebalancing process, revisiting: "Well, OK, my asset allocation target was one thing last year or five years ago. What should it look like now, given that I am older and closer to retirement?"

So you can look to off-the-shelf asset allocation guidance. We've got a spreadsheet that we often share of Ibbotson-related data for portfolios at various life stages, for people with varying risk tolerances.

I think, an important thing to keep in mind, though, if you look at something like that, you might see target date portfolios for, say, someone who's 45 and 50 and 55. What you don't want to do is change your asset allocation only at five-year intervals like that, because the risk is, if you wait too long, you could be having to rebalance into an inopportune market to make those changes. So, I think you want to be doing a little bit of this shifting year-by-year, rather than waiting too long to do it.

Stipp: So, maybe one of the points is, you know what that set allocation is to start out with. But you should also keep in mind, over the years, maybe as you're looking at your portfolio and looking at your targets, where you should be in five years from now or 10 years from now. And you can make an adjustment within those two ranges along the way, knowing that when you reach that age, you want to have this particular allocation.

Benz: Right, it's sort of a way of dollar-cost averaging into the correct asset allocation over a period of years. It helps ensure that you'll obtain a range of purchase prices for the securities that you are adding to, as well as those that you are subtracting from.

Stipp: And so speaking of dollar-cost averaging, the role of new cash, I think, is something that's important to talk about, because it's not like you are just shifting your portfolio because of market changes and the effect that has. You are also putting new money in. So can you be strategic in where you are putting that to have an effect on getting your portfolio where you want it to go?

Benz: You absolutely can. In fact, I often say that that's really the best, most tax efficient, cost-effective way to rebalance your portfolio. If you have new money to put to work, put it toward those asset classes that are looking lower, that you need to add to, rather than having to sell [from other asset classes], which could incur tax costs.

Stipp: I know that also people who are nearing retirement may be putting extra money to work because they, for example, can invest more in their IRAs?

Benz: That's right. So you are allowed catch-up contributions. For people under 50, the contribution is $5,000; for people over 50 it's $6,000. And in 401(k) plans, it's an even more generous catch-up contribution, $22,000 in 2011.

So, yes, if you are putting extra money to work because you can afford it and because you are making those catch-up contributions, that will give you an opportunity to address those imbalances and to shift your overall asset allocation into a more conservative direction as you near retirement.

Stipp: So, Christine, a question that is more timely. Let's say that I have looked at my portfolio and I do see that some adjustments need to be made, and maybe I need to get some more money out of stocks and into bonds, because this is what the asset allocation plan is suggesting. But maybe I think now is not a great time to be sinking a lot of money into bonds or taking money out of stocks, which could have better prospects. And of course we don't know for sure, but let's say that I have this thesis. How should I make those two things come together, because I have this investment thesis, and then I have this portfolio plan, and they're at odds?

Benz: Right, and there I say--and I know is say this again and again and again--but I think staging it over various time periods will make a lot of sense, rather than sinking a lot of money into an asset class that may look somewhat pricey right now. I think that planning to deploy that cash over a period of months is a great strategy for addressing your asset allocation imbalance.

Stipp: Last question for you Christine: So, we have been talking about retirement, and this is one of those situations where you save for a long time, and then you rely on that portfolio for a long time. But other things might make a difference in how closely you want to watch your allocations, which might include college savings. What's the story there, and how might you track your portfolio a bit differently in that case?

Benz: I think that's a great point, Jason. With college savings, in particular, you will spend that money over four years, maybe five if your child takes a little longer. But that's a very short drawdown period. So you need to be sure, as your child becomes a junior or senior in high school, you need to be sure that most of that money is locked down. Even though you won't earn much on cash or short-term bonds, you really cannot risk having too much in equity. So at the point that your child is entering high school, or certainly getting to the end of high school, you want to watch that portfolio like a hawk and make sure that its asset allocation is very conservative.

For retirees or people nearing retirement, they maybe can afford to tolerate more fluctuations, or they definitely can, because they will be drawing on that portfolio for many years. So they absolutely don't want to eradicate equities from their portfolios at that point in their lives.

Stipp: All right, Christine, some great tips on rebalancing and portfolio allocation shifts. Thanks for joining me today.

Benz: Thank you, Jason.

Stipp: For Morningstar I'm Jason Stipp. Thanks for watching.