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I often get asked the question, “how should I invest within my company retirement plan.” In specific, clients want to know how to invest in their company 401(k) or 403(b) plans. These plans offer the opportunity to grow money on a tax-deferred basis by investing in a number of mutual funds and to save a percentage of every paycheck. These are very good plans and I encourage all my clients to participate fully in these plans. I know that some advisors don’t encourage tax deferred saving, but fortunately, they are in the minority. You should save as much as you can in your company retirement account. Read A Compounding Tale to get a full appreciation of how your money grows over time, read A Coffee Tale to understand how consistent saving is a good habit and read A Partnership Tale to understand the power of tax-deferred compounding.
If you don’t believe me, consider the following; I typically charge my clients 1% of whatever money they trust me to invest for them. It is in my best interest or said in a different way, it is to my financial advantage to recommend that clients choose to not participate in their company plans. Yet I don’t. I can’t make a stronger case than this for investing in your company plan. Do it.
So what is rebalancing? Rebalancing refers to rebalancing a portfolio. In order to rebalance you have to own more than one investment in your portfolio so you have to have what is called an asset allocation. What is asset allocation? You can read An Asset Allocation Tale for a full explanation but in a short version it’s how you allocate the money that you invest either within your company plan or personal portfolio. Using the company plan as an example, you can invest in 1, 2, 3 or more of the options that your plan offers. If you choose to invest in more than one option in your plan, and I recommend that you choose at least 4 options, then rebalancing becomes important and a profitable tool to have in your financial arsenal.
Lets look at an example of rebalancing your portfolio. Assume a hypothetical portfolio of $10,000 and that it is currently divided into 2 mutual funds. For whatever reason, you wish to have a portfolio that is 50% invested in Fund A and 50% invested in Fund B. One day you wake up, look at your portfolio and notice that it isn’t balanced any longer. Fund A is now worth $6,000 (60%) and Fund B is worth $4,000 (40%). How did this imbalance happen? It happened because Fund A outperformed Fund B. For this tale, how it happened is not important. What do you do now that your portfolio is 60/40 instead of 50/50? In order to rebalance, you will sell $1000 worth of Fund A and buy $1000 worth of Fund B. This brings you back to balance and you have successfully rebalanced your portfolio. Let’s make things a little bit more difficult and more real world by adding 2 more funds to your portfolio.
If we go back to our original 2 fund portfolio where 60% was in Fund A and 40% was in Fund B and you want to add two more funds to your portfolio, how do you rebalance? Assume you want to add Fund C and Fund D, and that you want to equally weight your allocations. You have $10,000 in total and your goal is to have $2500 or 25% in each of the 4 funds so you need to sell $3,500 of Fund A, you need to sell $1,500 of fund B and you need to buy $2,500 of Funds C and D. Once you have completed this process, you are rebalanced and you have an asset allocation of 25% to each of the 4 funds. Congratulations, you’re on your way to financial success. The last step of the process for retirement plans is to allocate the same 25% out of every paycheck to the same 4 funds.
Lets add some complexity and say you want to add money to your portfolio every pay period. Over time you will contribute every pay period an equal amount to all 4 funds. As an example, if you contribute $400 per pay period you will invest $100 into each of the 4 funds. What you will also notice over time is that the 4 funds will have different performances. I call this “The Divergence Effect.” If you examine your holdings periodically you will notice that this divergence can get quite pronounced. What you need to do is establish a rebalancing rule that doesn’t make you a slave to your portfolio but doesn’t let the weighting of your portfolio get out of hand. By weighting I mean having too much or too little of your money in one fund or asset class. I find that re-balancing back to equality (25%) should take place anytime one fund performs either materially better or worse than the others such that it now represents either too much or too little of your portfolio. A good number to use is 30% (too much) and 20%(too little).
For example, if one day, maybe a year from now, you examine your end of day statement and you see the following, your portfolio is worth $20,000 and Fund A is worth $6000 (30%), Fund B is worth $5,000 (25%), Fund C is worth $4,500 (22.5%) and Fund D is worth $4,500 (22.5%). What do you do? You sell $1,000 of Fund A and buy $500 of Fund C and D. After you do this you are once again rebalanced with an allocation where you have 25% of your money in each of the 4 funds. In this example you rebalanced because Fund A became too large a portion of your portfolio. It diverged from the target allocation of 25%. Conversely, if a fund becomes too small a percentage of your portfolio, for this example 20% also due to divergence you would also rebalance.
Please note, over many years of advising clients and watching them manage their retirement plans, I actually recommend they limit themselves to 4 options. More than 4 options gets unwieldy making the rebalancing math complicated which leads people to abandon rebalancing. As I state in the subtitle of this tale, rebalancing is a free breakfast. I say this because if diversification is the only free lunch on Wall Street, then rebalancing between stocks and bonds is surely the only free breakfast. We learned in An Asset Allocation Tale that you can add approximately 1% per year rate of return to your portfolio by holding a balanced mixture of stocks and bonds and then rebalancing when they diverge too far from your original or target allocation. You need to incorporate rebalancing in your life and at a minimum in your company retirement plan. Speak to any of my clients or relatives and they will tell you that, I actually recommend they allocate 25% of their money to 4 funds and rebalance anytime that one of their funds reaches either a 30% or 20% threshold. This is a very simple rule and one that anyone can understand and implement.
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So, does rebalancing work best by selling the funds that exceed their allocation, or is it ok to do it with new money coming in, instead? I’ve a fairly low balance at this point, and I can see my profits getting eaten up by sales charges rebalancing.
The question is how often should a person rebalance their portfolio and how should they do it specifically.
Let’s lay some groundwork before we answer the question. To properly rebalance you must have your portfolio with a firm that can accommodate rebalancing at no cost. You must also have a diversified portfolio as well as a target stock and bond asset allocation that suits your situation. Concentrated, focused or individual stock portfolios are not meant to be rebalanced so don’t try it because it will lead to disaster.
Rebalancing works in three dimensions. The first dimension and by far the most important is the ratio of stocks to bonds. Our research over the last 80 years using daily data shows that almost all the benefits from rebalancing are gained in the first dimension. This means that you should always be aware of the ratio of stocks to bonds in your portfolio. When one gets too far ahead of the other it is time to rebalance. The second dimension is the ratio of stock asset classes to other stock asset classes within the portfolio. The last and third dimension is the ratio of bond asset classes to other bond asset classes in the portfolio.
The rest of this response will focus on how to rebalance in the first dimension or the stock to bond dimension. There are only three ways to rebalance. The first is rebalance based on frequency or time. You rebalance every 2 weeks or every month or every quarter or some other nonsense. Don’t do it. This form of rebalancing does not capture the true benefit from proper rebalancing. It does not maximize the objective of rebalancing which is to reduce risk based on a target allocation. The second is to do it once a year. I actually like this much better for individual investors since it is a once a year thing and dose not require constant supervision. The third and best method is formulaic rebalancing.
Our rule of thumb is to rebalance whenever the ratio of stocks in the portfolio diverges from the target allocation by more than 10%. As an example, for a 50/50 portfolio whenever stocks are either 45% or 55% of the portfolio we rebalance. For a 60/40 portfolio whenever stocks are either 54% or 66% of the portfolio we rebalance. Please note that if you have a 100% stock or bond portfolio you can’t rebalance in the first dimension and you lose the effectiveness of rebalancing. It is an obvious point but important. It is one of the main reasons why you see very few portfolios with allocations in excess of 80% in stocks or with less than 40% in stocks.
If you use our 10% band for rebalancing you will find you get a signal every 8-10 months. Some periods where the markets are volatile will give you frequent signals and others will have you go for long stretches where you do nothing. We prefer this dynamic method for rebalancing because it takes into consideration market volatility.
Mechanically, we don’t reinvest our dividends or interest. This means that when we rebalance and sell an asset class we add this to our money market funds. We include money market funds as part of our bond allocation. This leads to two more questions. If you must rebalance because your first dimension or ratio of stocks to bonds is outside of the target allocation band by 10% which asset classes do you sell and which do you buy.
There are only three logical choices that you can make when selling or buying when you get a rebalancing signal. Number 1—You can sell and buy some of each so that the ratio of the stock and bond asset classes remains the same after rebalancing. Number 2—You can overweight towards the leading or best performing asset class or classes or overweight towards the lagging or worst performing asset class or classes. Number 3—You can rebalance everything back to the original asset allocation. It is important to recognize that at this point you are simply tweaking your portfolio. You are now in the second and third dimension but not the most important one. Rebalancing between stocks and bonds far exceeds the importance of individual stock or bond asset class rebalancing.
For those that are curious—stock asset classes have a persistency effect that means that winners keep winning and losers keep losing. Stock asset classes have a persistency effect. This means that you will make more money if you allocate all of your money to the asset class that is performing the best and raise money from the asset class that is performing the worst. I have not yet released a tale addressing this persistency effect so for now I suggest the reader simply go with alternative Number 3 and rebalance back to the original allocation.