Rebalancing your portfolio is one of the keys to successful investing over time. Rebalancing means adjusting your holdings—that is, buying and selling certain stocks, funds, or other securities—to maintain your established asset allocation. For example, let's say your asset allocation is 60 percent stocks and 40 percent bonds. If stock prices go up for a few months, your allocation to them might rise to 70 percent. That means you have to sell some stocks to get back to your desired level. It's important to maintain your asset allocation because it keeps your tolerance for risk at the most comfortable level.
For most investors, rebalancing twice a year is sufficient to make sure their asset allocation isn't getting out of whack. Mark the dates you want to rebalance on a calendar you check the most. That way you won't forget.
Here are three reasons why rebalancing is important:
Rebalancing forces you to take profits from investments that have run up and put money in things that have merit but haven't gone up. When one piece of your pie goes up, you might get greedy and want to put more money in it. You need to fight that urge. Actually, the best thing you can do is take profits from your winners from time to time.
A good rule of thumb for when it's necessary to rebalance is when an asset class weighting has changed by five percentage points. Let's say your allocation in small-cap stocks rises from 15 percent to 20 percent. If you don't trim your small-cap holdings back to your 15 percent target allocation, the risk in your investments is increased. In other words, if small-caps suddenly start falling, 20 percent of your portfolio will drop with them rather than 15 percent.
On the flip side, your allocation in international stocks may have dropped from 20 percent to 15 percent. That means prices have dropped, presenting a buying opportunity. Look for assets that stand to rise in price in the future. Ask your adviser for help if you don't feel comfortable researching areas of the market on your own. Remember, you want to buy low and sell high, not the other way around.
Rebalancing gives you the opportunity to review all of the mutual funds in your portfolio. While you're examining the changes in your investment allocations, you can also evaluate your funds. If a fund you own has risen 10 percent, you could be too concentrated in one fund. You might want to take those profits and buy a second strong fund in the same asset class.
In addition, you can search for a better fund if one is not living up to your expectations. With so many good funds available, there's no reason to hold on to a fund if you're not happy with it. Check U.S. News's Best Funds site, Morningstar, or other financial sites to research funds or seek advice from your financial adviser.
Rebalancing smooths investment returns. All asset classes go through cycles. Professional investors will pile into tech stocks or love anything related to gold. Then before you know it, they hate them and move on to the next best thing. Most people aren't lucky or smart enough to get in the best sector or certain stocks at the right time and then switch into other ones when prices are the most attractive.
That's why dollar-cost averaging works well for many investors. Dollar-cost averaging means putting a set amount of money in investments (usually stocks and mutual funds) every month over a long time period. No matter the price of the investment, you're buying $100 (or some other set amount) worth of shares each month. When prices are higher, you buy fewer shares. Conversely, you buy more shares when prices are lower. As a result, your average cost per share will reflect both the discounted prices during a bear market and the premium prices during a bull market, rather than just the premium prices.
The beauty of dollar cost averaging is that you don't have to figure out when to get in and out of any area of the markets. It gets you in the habit of investing every month, so the value of your account will increase over time. You may not realize this, but if you're putting money into a retirement plan at work or a brokerage account every month, and those contributions are programmed to make regular purchases of specific securities, you're using dollar-cost averaging.
Ultimately, dollar-cost averaging and rebalancing regularly smooths returns during bumpy markets. You may not generate the largest gains during a rising market, but you may not get hit as hard in falling markets. If you stick with your asset allocation and periodically rebalance, you can generate a decent average return over time.
Adam Bold is the founder of The Mutual Fund Store, which provides fee-only investment advice with locations coast-to-coast. He's also host of The Mutual Fund Show, a call-in radio program broadcast across the country. Bold is author of the book The Bold Truth about Investing (April 2009). Bold is Chief Investment Officer of The Mutual Fund Research Center, an SEC-registered investment adviser, which provides mutual fund and asset allocation recommendations, and research to stores in The Mutual Fund Store system.