Rebalancing your mutual fund portfolio on a regular basis
maintains the desired asset allocation in your investment strategy -- it is one
of the important keys for effective risk management. Yet, most
investors ignore this relatively simple procedure, primarily due to (1) their
failure to see the benefits of periodic rebalancing and (2) their
uncertainty of the proper procedures. Let's review these factors in a question
and answer format.
What is rebalancing?
Rebalancing is the periodic adjustment of a portfolio to restore the
desired asset allocation mix.
Why is rebalancing important to my mutual fund portfolio?
The primary objective of rebalancing is to manage risk
by maintaining effective diversification (i.e.,
allocating investment assets among different fund categories to
achieve both a variety of distinct risk/reward objectives and
a reduction in overall risk). By monitoring that your portfolio is
not overly dependent on one or more fund categories, you
control risk by curtailing over-weighting and under-weighting -- thus
reaping the the full rewards of effective diversification in your investment
Rebalancing forces you to trim back on winners and increase undervalued
categories -- a principal of buy low, sell high. However, many investors do just
opposite....they chase the best performing funds and end up buying high and selling low, which
of course significantly increases the volatility (risk) of their portfolio.
How often should I rebalance?
You should review rebalancing at least annually; many investors rebalance in early
January (after year-end statements). Others may choose semi-annual and, to
a much lesser extent, quarterly intervals.
What is the best way to rebalance?
For tax-deferred accounts, just shift (transfer) assets to restore you target allocation
since no taxes would apply. Any new contributions should follow the
desired asset allocation mix.
For taxable accounts, it is best to add (or increase) new contributions to the
under-weighted allocations and thus avoid incurring taxes.
However, if a particular fund had exceptional results within a year, then consider
selling a portion of that fund to restore the original allocation; in essence, you would be
protecting your gain and, at the same time, would then be using the gain to buy
the under-weighted funds
-- most likely at a lower than average prices. If taxes will occur upon a sale,
then try to minimize the effect by incurring long-term capital gain taxes rather
than interest or short-term gain taxes.
What is a recommended allocation variance which would trigger rebalancing?
Rebalance when a fund has varied by the greater of either 15% or ten
percentage points (alternatively, rebalance when a fund varies by either 20% or fifteen percentage points,
but that may be too great of a variance for some investors).
Example using the following scenario: a four-fund balanced-oriented portfolio
(50% stock funds and 50% bond funds).
Original Asset Allocation Mix
Value - 35%, Small Blend - 15% | Short-Term Corp - 20%, GNMA - 30%
Asset Allocation Mix after One Year
| Large Value - 30%, Small Blend - 12% |
Short-Term Corp - 23%, GNMA - 35%
In this example, all of the funds meet the allocation variance guidelines of either 15% or
percentage points and would be rebalanced to the original asset allocation mix.
What if only one or two funds in this scenario exceeded the allocation
variance? For tax-deferred accounts, just shift all fund allocations to the original mix.
In taxable accounts, preferably adjust the allocation mix by directing new contributions
to the under-weighted funds to restore the original allocation -- this
avoids unnecessary taxes; however, if portfolio allocations are drastically
different from the original mix, then a shift of a fund (or funds) allocation to restore
the original mix may be the best course of action.
What are other factors in rebalancing?
It is important to realize that a change in allocation percentage for each fund in a portfolio
does not necessarily reflect the exact gain or loss for that particular fund. In
other words, a specific fund could have little gain or loss, yet its allocation
percentage may be affected by the gain or loss of another fund or funds in the portfolio.
In the above example, it is unlikely that a short-term bond fund would generate a 15% gain in one year, yet its allocation percentage is increased
due to the decrease in the equity funds.
Note also that volatility in growth-oriented portfolios will be greater than
in balanced or income-oriented portfolios, all other criteria being equal.
Changes in allocation percentages may be greater, and more frequent, due to
the higher percentage of stock funds.
What if my objectives and risk tolerance have changed or if a specific fund has
exceptionally poor performance?
If your return objectives, time horizon or risk tolerance has changed, you
will definitely need a new asset allocation strategy that reflects your
revised investment criteria; depending upon the degree of change in your
criteria, some existing funds will likely be replaced. If an existing fund has
performed below-average in its
category, then fund
replacement is certainly a consideration. In either of
these instances, refer to "When
To Change Funds" for detailed information and guidelines.