Rebalancing Guidelines

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Rebalancing Guidelines

Rebalancing may at first remind TV buffs of the plate-spinning act from the Ed Sullivan Show—the guy who kept all that fine china spinning precariously atop long, flexible rods. How stressful it must have been to keep all those place settings gyrating at once, running back and forth to give each rod a flick and keep it all from toppling down.

Effective rebalancing doesn’t have to be nearly as tension filled. You don’t need to keep daily tabs on your portfolio and tweak it weekly. Instead, consider these guidelines.

Guideline 1: Rebalance only on an as-needed basis

We’re not saying you shouldn’t look at your portfolio periodically. But resist the urge to tinker. You’ll save yourself unnecessary labor and, if your portfolio includes taxable accounts, a good bit of money. That’s because rebalancing requires paring back the winners, which means realizing capital gains and, for the taxable investor, paying Uncle Sam.

Some people like to rebalance on a calendar-year basis—say, every December. But a better strategy is to conduct a thorough checkup of your portfolio once a year, but rebalance only when your portfolio’s asset allocation is out of sync with your targets. For example, you might only rebalance when your portfolio’s allocations to stocks and bonds diverge from your target allocation by five percentage points. (On your investment policy statement, you can specify ranges for your allocations to each asset class. For example, your target allocation to stocks may be 55%, but you’ll let the weighting go as high as 60% or as low as 50% before making changes.) Hands-off investors could give their portfolios an even longer leash, rebalancing only when their allocations to the major asset classes diverge by 10 percentage points relative to their targets.

Guideline 2: If you rebalance just one thing, make it the stock/bond split

Your cash and bond stakes are vital to keeping your portfolio’s risk in check. So if you don’t want to take the time to rebalance your entire portfolio on a regular basis, at least restore your cash and/or bond positions when they’ve diverged widely from your targets.

Guideline 3: Be a tax tactician

Keeping your portfolio’s volatility in line isn’t satisfying if your rebalancing strategy means you also wind up with poor aftertax returns. Here are a few things you can do to minimize taxes:

• Use new money—say from a bonus or a gift—to restore your portfolio’s balance. Adding fresh dollars to the laggards in your portfolio helps you avoid the tax consequences of selling the winners. 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.
• If you need to scale back in certain types of investments that you own in both taxable and tax-deferred accounts, sell the securities in the tax-deferred accounts first. That way, you’ll limit how much you’ll pay in capital gains taxes.