You know the golden rule of investing: buy low, sell high. But putting this old axiom into practice when it comes to balancing a portfolio means summoning the courage to sell winning investments and buy others that have plunged.
After 2008’s tumultuous market, rebalancing might mean selling some government bonds and plowing the money into domestic and international stocks, real estate, and corporate bonds to bring your portfolio back to its intended asset allocation. If you had done this at the beginning of 2000, for example, you would’ve sold off growth-oriented technology stocks and bought up value stocks, bonds, and real estate. Get the picture? It really is the ultimate buy low, sell high. “Rebalancing keeps you from making horrific mistakes by staying out of things that eventually go south and taking on things that eventually go north,†says Ernie Ankrim, senior markets adviser with Russell Investments.
First Stop: Asset Allocation
It’s impossible to rebalance if you aren’t sure of the asset allocation you’re hoping to achieve in the first place. In fact, it is probably the most important investment decision an investor can make. Proper asset allocation can account for more than 90% of portfolio returns, according to the Association for Investment Management and Research.
Most people need a portfolio consisting of at least four asset classes: domestic stocks, international stock, bonds, and real estate, says Richard Ferri, founder and CEO of Portfolio Solutions L.L.C., an investment management company based in Troy, Michigan, and author of All About Asset Allocation (McGraw-Hill; $19.95). The exact mix depends on your risk tolerance and time horizon. Younger people will want to opt for a greater proportion of stocks and therefore more risk, while those nearing retirement should have a bigger weighting in bonds.
The theory behind asset allocation is that different assets respond differently to a range of market environments. Some people liken asset allocation to putting together a good basketball team. You need a varied group, who together have complementary skills.
Think about it: A team of five Shaquille O’Neals isn’t a guaranteed winner. Sure, you need a player who can muscle in dunks from under the basket, but it’s also necessary to balance those qualities with other players who are more adept at, say, hitting three-pointers and making foul shots. The same is true with your portfolio. Each asset helps you achieve a specific objective.
A mix of assets helps to iron out rough patches in the markets, since it’s unusual for both bonds and stocks to fall simultaneously. Pick an asset allocation that truly
reflects your time horizon and appetite for risk through different periods. “Generally, a real asset allocation shouldn’t change from year to year, and it shouldn’t change with market conditions either,†says Joel Ticknor, a fee-only, certified financial planner in Reston, Virginia.Keeping the Balance
Once you’re confident you have an asset allocation that suits you, you are ready to put portfolio rebalancing into practice. One way is working within certain parameters, or “bands.â€
Say you decided to have a 60%Â allocation to stocks and set your bands at plus or minus 10%. That means each time the stock portion of your portfolio reaches more than 70% or less than 50%, you would rebalance. Had you used this technique over the past year, you would have done a lot of rebalancing due to extreme market volatility. For that reason, most people are better served by another method in today’s volatile market: a calendar rebalancing methodology, either annually or quarterly.
“If you’re rebalancing more frequently than quarterly, you’re not adding too much value and will probably be too focused on the short term,†says Chris Cordaro, chief investment officer with fee-only wealth management firm RegentAtlantic Capital L.L.C. in Morristown, New Jersey.
Proceed With Caution
If you realize that your rebalancing efforts will cost too much in taxes and transaction fees, you may want rebalance less frequently. Employer-sponsored accounts are often the best place to rebalance without incurring transaction costs and capital gains tax. Portfolio rebalancing is an art rather than a science. It can help you to buy stocks when they are undervalued and dump holdings that are likely heading for declines.
This story originally appeared in the April 2009 issue of Black Enterprise.