Portfolio Rebalancing


Portfolio rebalancing is one of the basic principles of investing. It involves a periodic scheduled evaluation of your portfolio to examine the allocation of assets in comparison with the target.

If an asset class has risen in value to exceed its target, the investor must decide whether to sell a portion of the asset to bring it back in line with the target or raise the target. There are likely other classes that have fallen below their target and may represent a more attractive investment in bringing the allocation back in line. It is extremely difficult to "sell a winner and buy an asset in an underperforming class," but this is exactly the kind of discipline necessary to achieve the goals of your investment plan. Different asset classes tend to perform at different levels over time, hence the reason for diversification.

Assets that have performed at above-average levels may now be overvalued, and those that have underperformed (according to the market) may now represent an opportunity for growth. This approach allows the investor to realize some of the gains in the portfolio. If the goal is to buy low and sell high, this discipline fits that goal.

Within any asset class, there may be stocks or funds that appear to underperform. If research does not indicate circumstances that are likely to change, it may be best to look for a substitute in the class that is performing better. There may, however, be circumstances in which the fund or stock is likely to recover, and are an opportunity to buy low.

When rebalancing is considered, it is also prudent to reevaluate asset allocation. Professional advice or research may be of value, because domestic and international economic conditions change over time. Based on market conditions, changes in asset allocation may be considered instead of rebalancing.

Reevaluate your portfolio at least annually (or when changes in market values have changed your asset mix by 10% or more). After considering multiple strategies as well as all the costs and benefits associated with those strategies, the Vanguard Center for Investment Counseling & Research concluded the following: "For most broadly diversified stock and bond fund portfolios, annual or semiannual monitoring, with rebalancing at 5% thresholds, produces an acceptable balance between risk control and cost minimization." (Click here for more information.)

Maria Bruno, an investment analyst with Vanguard’s Investment Strategy Group, suggests that rebalancing is counterintuitive. "It means that you are giving up on your winners and going into your losers," she said. But consider that rebalancing is not about returns but about reducing volatility.

There are potential tax consequences related to rebalancing. Suggestions for reducing taxable gains include rebalancing less frequently, rebalancing with "new" investment money, and rebalancing in nontaxable accounts whenever possible. The philosophy of rebalancing of investments is opposite to the idea of "market timing," which has not been shown to be successful. Not all financial advisers embrace rebalancing – for a contrarian position, click here.

Remember, investing requires involvement and discipline. Reevaluate your results periodically, and make changes in your plan when indicated.

Disclaimer: The views and opinions expressed in this article are those of the author. Dr. Bailey is not a financial adviser; the information is this column is general, not authoritative, and cannot substitute for the advice of a professional financial planner.

Dr. Bailey is an ACS Fellow on the Board of Regents and a colon and rectal surgeon at the Methodist Hospital in Houston.

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