The most important decision an investor can make in a long-term investment plan is deciding what percentage of his investable assets to "allocate" to each asset class.  With employer retirement plans, these asset classes ordinarily include funds that invest in: cash equivalents, bonds, and stock (and sometimes, a combination of all three).  

 Generally, in a given economic environment, one asset class will tend to perform better or worse than the others.  In the late 1970s, "cash was king," handily outperforming stocks and bonds.   From 1995 through 1999, stock market returns dwarfed cash and bonds.  And from 2000 through 2002, bonds led the pack.  Few (if any) prognosticators can consistently predict which asset class will lead in the future.  But for the long-term investor that really doesn’t matter.  Once he selects a suitable "asset allocation" (i.e., one that reflects his goals, time horizon, and risk tolerance), his task then is to make certain that his portfolio doesn’t veer too much from his chosen allocation. That’s where rebalancing comes in.

 Let’s say that an investor has a prescribed long-term asset allocation of 15% Cash Equivalents, 50% Bonds, and 35% Stock.  Let’s also assume that he established this allocation at the beginning of 1999, and didn’t add to nor make withdrawals from his portfolio during the year.  See Row 1 in the Table Below.

 Cash Equivalents

 Bonds/Fixed Income Securities





 10% (Year1) End Value

 35% (Year1) End Value

 50% (Yr1) End Value

 +5% Rebalance

 +15% Rebalance

 -15% Rebalance




 If he re-visited his Asset Allocation at the end of 1999, notice that the equity (i.e., stock) portion of his portfolio swelled to 50%, with the bond portion dropping to 35%, and cash equivalents shrinking to 10% (See Row 2 of the Table).  In this situation the "casino mentality" would be to suggest doing nothing and "letting his winners ride".  However, a prudent investor would take the gains from his "winning asset class" (in this case, stock) and buy the asset class that did less well (in this case, cash and bonds) to bring him back to his original allocation (See Row 3).  This process is called "rebalancing".

 When you rebalance you are really selling "your winners" and buying "your losers," not a very appealing proposition for most people, at least in the short term.  However, if you look a little closer, you’ll also recognize that rebalancing "protects you from yourself" by forcing you to "sell high" and "buy low" every year.  In our illustration, who was to know that bonds would outperform stock for the next three years (2000-2002) and that the stock market would tank during that time.  Those who hadn’t rebalanced would have lost a larger portion of their portfolio in the stock market downturn because the stock portion had swollen to a much larger proportion of the whole.    

 Rebalancing takes discipline and courage.  It typically puts you in the position of liquidating investments that have performed well recently and buying investments that are may be out of favor at the moment.  Think back to the investment environment at the end of 2008.  The stock portion of investors’ portfolios shrank dramatically during 2008.  Rebalancing would have asked investors to add to their stock market holdings (assuming they had set a valid asset allocation) just at the time when "pundits" were predicting further market losses.  However, investors who did rebalance were rewarded (with the greatest annual stock market surge since World War II) in 2009.  Rebalancing doesn’t always work that dramatically, but 2009’s market performance is an important reminder of the importance of rebalancing.

 Experts differ on how often you should rebalance but most agree that you should do so at least once a year.  Some experts also suggest rebalancing if your "asset allocation" drifts more than 10% from its prescribed allocation during the year.  For investors the key is to rebalance at least annually and to have a plan in place to make it happen.   For employees with a significant portion of their assets in tax-deferred accounts, rebalancing can occur without triggering any taxable capital gains.  Some employees prefer to rebalance by directing their new contributions to their "under-performing" asset classes until they return to their prescribed asset allocation.  Though an acceptable option, it’s easy to forget to restore where you direct new contributions once you’ve completed the rebalancing process.  Again, the key is to choose a rebalancing method and stick to it.

- 10/21/2010