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Rebalancing your Portfolio

Over time, the asset classes in your portfolio will grow or shrink as the markets change. Your portfolio will slowly drift away from the plan you established and reintroduce risk as certain investments become weighted heavier than others. Rebalancing aims to periodically adjust your investments so that they match your asset allocation plan again. Rebalancing also allows you to reanalyze the goals of your portfolio and make changes to meet your new allocation plan. Rebalancing your portfolio reduces risk, ensures your investments remain balanced to your specifications, and provides an opportunity to keep everything on track as you progess.

Annual Rebalancing

After you have established your asset allocation plan and set up your portfolio, the changes in prices from day to day will gradually change the allocation of your existing investments. It is important to rebalance your portfolio on occasion to reset the size of each asset to match your target plan. Rebalancing your portfolio can occur in two ways: selling and buying until your assets match your allocation plan or changing what assets you invest into in the future.

For tax-deferred accounts such as 401k plans or IRAs, selling and buying different assets until your portfolio matches your asset allocation plan may be easier and faster than trying to plan future purchases. For accounts that may suffer brokerage fees or capital gains taxes, changing how you invest future contributions may save you money in the long run. Rebalancing on an annual basis ensures your assets constantly meet your risk tolerance and maintains diversification.

Sample Target Allocation
A sample portfolio with the owner's target asset allocation plan.

Actual Allocation after a year
The same portfolio a year later. Changes in the markets have changed the allocations and the
owner will need to rebalance the portfolio to realign it with the risk expectations originally set.

Gradual conversion to safer investments

As you grow older, it is important that your asset allocation adjusts to ensure your portfolio maintains its real value. If you continue to invest 5 years before retirement the same way you invested 25 years earlier, you may be undertaking a great deal of risk as your portfolio is subjected to short-term changes in the market. To reduce the risk of losing value in your portfolio, your asset allocation should gradually change towards a more conservative allocation of more bonds and less equities. As you reach retirement age, it is important to have some of the portfolio in cash assets such as a money market account to draw on for daily living and unexpected events. While no portfolio ever needs to be entirely cash or bonds, the amount of equities should decrease over time for most investors.

Assets become conservative over time

Target Retirement Funds

Many mutual fund companies have recently developed funds that have a predefined asset allocation and automatically rebalance and grow more conservative as they near their target date. Each fund is associated with a year in which the owner would theoretically retire. As that date approaches, more and more of the fund becomes bonds and other low risk investments. These funds are ideal for people who do not want to spend a lot of time worrying about the optimal asset allocation or remembering to rebalance every year. Many investors want a more customized portfolio or have different risk tolerances than the target retirement funds provide and choose to make their own allocation plan.

Tactical/Strategic Asset Allocation

Tactical Asset Allocation refers to moving assets or investing at a specific time in order to leverage changes in the market. In all other forms of investing this is called market timing. The theory behind Tactical Asset Allocation is that an investor can take advantage of a dip in the market to invest in that sector or asset class while it is bound to go up later. If someone feels the stock market is going to be weak next year, he or she may change the asset allocation plan to include more bonds and fewer stocks as a way to reduce risk. Just like with individual stock market timing, Tactical Asset Allocation is unlikely to work as it requires insight into future markets and active management of your portfolio.

Next: View sample portfolios to compare to your allocation
Page last modified 3/21/2012