It's a Balancing Act
You’ve carefully weighed in your own mind how you want your retirement portfolio to look:
just the right amount of your assets allocated to stocks versus fixed-income investments. You feel
comfortable with the growth/income and risk profile of your portfolio, and you have carefully
diversified your investments over all the investment categories, and even within each category. Then,
inevitably, the market jumps up or down, and your portfolio is thrown completely off balance.
What should you do?
First, relax. Your asset allocation guidelines are just that—guidelines. Aim to hit your percentage asset allocation
targets over the long run, but be prepared to accept
short-run variations caused by normal market
cycles that will affect large stocks, small
stocks, international stocks, and
bonds differently.
How much variation should
you tolerate before you need to
take action to rebalance your
asset allocation?
There really is no precise
answer. But when asset allocations
are off 10% or more, the process
of rebalancing should start.
As an example, let’s say your
broad asset allocation guidelines
call for 70% invested in stocks and
30% invested in fixed income. If stock
prices rise and cause your allocation to change
to 80% in stocks and 20% in bonds, it’s probably time
to rebalance.
If your 80% stock investment remains well-diversified
but it is simply too large a portion of your retirement
portfolio, it makes sense to nudge the percentage back
toward 70%. How should you accomplish this?
Your first choice should be to rebalance using your
current periodic contributions. If your portfolio value is
very large relative to your annual contributions, you may
have to redirect as much as 100% of your contributions
toward fixed income in order to rebalance. If redirecting your contributions won't result in a rebalanced portfolio over a year's time, then
you may need to rebalance by transferring some
portion of your stock holdings to your fixed income
investments.
But there's another important
benefit of rebalancing: It
forces you to buy low and
sell high. For example,
suppose that your
desired allocation to
stocks is 70%. In a
rising stock market,
the increased value of
the stocks in your
portfolio could easily result
in stocks amounting to
80% of your total portfolio. To
rebalance your stock allocation
back down to 70%, you would sell
stock while the market is relatively high
(selling high). Now, consider a falling stock market.
If the stock market is trending down, the stock
portion of your portfolio will fall below 70%. To rebalance back
up to 70%, you will have to buy more stock, but you will
be doing so when the market is relatively low (buying low).
Your retirement portfolio is a balancing act. Keep tabs on
your allocations quarterly and start to rebalance when broad
allocations deviate more than 10% from your guidelines.
Don't wait too long to regain your portfolio balance—the farther you lean in any direction, the harder it is to
catch your balance.
© 2008 AAII Journal
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