Finding balance in stormy seas

Posted by on August 6, 2009 @ 8:53 am in investing

Of all the generally accepted investment concepts called into question by the recent market environment, it seems to me that rebalancing is pretty close to the top of the list.

During late 2008 and early 2009, rebalancing your portfolio to stay close to your asset allocation target would have been almost a daily ritual—and one that would have felt increasingly futile. Even if you’d stuck to an annual approach, closing the gap between your actual asset allocation and your target would have required strong nerves.

Nevertheless, rebalancing remains an essential portfolio management tool. It does, however, require faith in another concept that’s been under fire: asset allocation. In order to rebalance, an investor must know the asset allocation to which he or she is rebalancing. Rebalancing is simply a means to that end. As such, an investor should reassess whether they’re rebalancing to the right target for them before moving any money around.

This is a good time to take a hard look at that allocation and ask questions such as, “Was I really too aggressive for what I was trying to do?” or “Was I truly diversified?” Granted, even portfolios that were diversified (stocks/bonds/cash) took a hit last year—but the damage they suffered was far less than that of portfolios that weren’t. So, let’s continue to accept the merits of rebalancing.

That said, I think there are ways to approach rebalancing so that it doesn’t feel like having to get across the Grand Canyon in a single leap. For example, you might decide to rebalance over a six-month period. Let’s say your target is a 50-50 split between stocks and bonds, and your current allocation is 38% stocks/62% bonds. You might take the 12-percentage-point gap and divide by six. The result: Each month for six months, you’d shift your allocation 2 percentage points closer to your target.

If you’re participating in a 401(k) plan, one way to do this over time would be to redirect contributions to the underrepresented asset class. There may also be “windfalls” in your future: a bonus at work, overtime pay, or the sale of other assets. If you’re retired, you could redirect fund distributions (e.g., dividends) to a fund that will help you get back to your target.*

Of course, rebalancing to your target asset allocation does just that, and no more. It’s not meant to increase your account balance. For that, you might need to save more—or get little cooperation from the markets!

A combination of both would seem to be a good compromise.

* If you’re in retirement, this Vanguard.com article may shed some light on how rebalancing can keep you on course.

Notes:

• All investments are subject to risks. Investments in bonds are subject to interest rate, credit, and inflation risk.

• Diversification does not ensure a profit or protect against a loss in a declining market.

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