Rebalance When Necessary - ch 17 Bogleheads Series
November 28th, 2006 by digerati
This is Chapter 17 in the Bogleheads series here at Catch a Gideon. We are going through each chapter in the book and letting you know what we learned from reading it. You should buy the Bogleheads Guide to Investing
Foolproof systems don’t take into account the ingenuity of fools. – Gene Brown
There is no one size fits all method of rebalancing your portfolio. Rebalancing is necessary because over time the proportions of assets will change due to market fluctuations. Rebalancing consists of selling some assets and buying others to get back to the proportions we planned for our portfolio.
Why Rebalance?
Rebalancing controls risk. Rebalancing returns us to the planned risk we decided on when creating our portfolio. Some stocks or assets will perform better than others, throwing asset allocation out o whack. Rebalancing also forces us to sell high and buy low, increasing the return of our portfolio.
Those who do not rebalance often try to ride on their overperformers and sell off their under performers. They believe this will cause higher returns. However, this is rarely the case. Over-performers are more likely to fall (since on average they will perform the same as the others). Under performers are more likely to rise since they are currently below average. This is referred to as return to the mean.
Do I need to rebalance?
We need to know our desired asset allocation. We discussed this in ch 8 of the Bogleheads series. Once our asset allocation is a certain amount (pre planned) outside of this asset allocation we need to rebalance. Rebalancing is important because the most important factor in returns is the ratio of stocks, bonds and cash.
When Should I Check my Portfolio?
This varies by person. Don’t check it every day, that’s pointless. Some will check every quarter,six months, or 18 months. Determine a time you want to reallocate your finances. For many this might be each spring, around tax time.
How do I track my Portfolio?
A great way to track your asset allocation is with personal finance software like Quicken or Money. These programs can show the deviation from your target allocations and even make suggestions or set alerts when you need to rebalance.
When Should I Rebalance?
Again, this varies per person. Some will do it quarterly, others annually. Find a schedule that is right for you. There are two factors to consider: taxes and costs. One reason to rebalance every 18 months is that you will always fall into the long term capital gains tax rather than higher short term taxes.
You could also rebalance based on deviation from desired allocation. You determine when your allocations fall outside of a 5% (or whatever %) band. When the allocation falls at 5% higher or lower than desired you would buy (or sell) that security to get back to the norm.
It is also possible to rebalance over time. If your holdings of cash fall 5% lower than desired, you may consider adding assets in your portfolio this year to cash assets. In this way, you gradually return to your desired allocations.
How to rebalance
There are many ways to get back to your target asset allocation. You may sell the outperforming asset clases and buy more of the underperforming ones. There are other options:
- Direct new money into funds below their target asset allocation
- Reinvest mutual fund distributions into a money market account and then use for rebalancing. This is instead of reinvesting dividends automatically into an outperforming fund.
- You can use a portfolio manger service (they suggest Vanguard’s Asset Management Service) which will automatically handle reallocation as necessary.
You should buy The BogleHeads Guide to Investing.
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