Rebalancing Principles for Your Fund Portfolio

If you ever watched the Ed Sullivan Show, you probably remember the plate-spinning act—the guy who kept all that fine china spinning precariously atop long, flexible rods. It was pretty impressive, all those place settings gyrating at once as the performer ran back and forth to give each rod a flick and keep it all from toppling down.

If you were to rebalance your portfolio frequently, you'd feel a lot like this guy. Relax. Rebalancing your portfolio doesn't have to be a juggling act if you follow some guidelines.

Don't rebalance too often

You needn't worry about rebalancing every quarter, or even every year. Research from Vanguard has demonstrated that investors who rebalanced their investments when their asset class exposures veered five percentage points from their targets reaped many of the same benefits as those who rebalanced more often. Moreover, investors who rebalance less frequently save themselves unnecessary labor and may even save a good bit of money, both in taxes and transaction costs. That's because rebalancing may trigger commissions to buy and sell. It also requires paring back the winners, which means realizing capital gains and, for the taxable investor, paying Uncle Sam. We're not saying you should tune out your portfolio unless there's been a big market movement; in fact, we think you should monitor your portfolio regularly to watch out for manager or strategy changes at your individual funds. But resist the urge to tinker unless one of your funds has significantly changed its strategy.

If you rebalance just one thing, make it the stock/bond/cash split

Your cash and bond stakes are vital to keeping your portfolio's risk in check. Because bonds don't generally move in sync with your stock investments, a simple strategy of restoring your cash and bond funds to their original weightings once they veer five or 10 percentage points will dramatically lower your portfolio's overall risk.

Mind the drag of taxes when rebalancing

Taxable investors, take note: Concentrating your rebalancing efforts in your tax-sheltered accounts can avoid triggering taxable capital gains. (Even if you sell winners that you hold within your 401(k) and IRA and use the proceeds to bump up your weightings in laggard holdings in those same accounts, you won't pay capital gains taxes.) And if you must rebalance within your taxable account, consider doing so by adding new money to the asset classes and categories that have lagged rather than selling winning holdings. If you don't have new money to put to work, consider having your funds' income and capital gains distributions paid into a money market account, then using that cash for rebalancing.