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Rebalance Your Asset Allocation Guide

By in Advanced Investing, Asset Allocation, Bond, Investing, Mutual Funds, Personal Finance, Stocks | 15 comments

Earn More by Rebalancing Your Asset Allocation

What if I said that you could earn an extra one quarter percent return on your portfolio every year by doing a simple task? A recent Wall Street Journal article reported that investors who regularly rebalance their investment portfolios increase their returns. It takes about an hour to rebalance your asset allocation and you will likely receive an added return every year. Although 0.25% isn’t huge, every bit of investment returns adds up.

Another solid reason to rebalance is to minimize risk. Even the most aggressive investor would prefer less investment volatility. 

Here’s a simple example to show the value of an extra quarter percent return each year. Start out with $25,000 and don’t add another cent to your investment account.

After 25 years, with a 7% annualized investment return, your account will be worth $135,686.

Now, imagine that your annualized investment return is 7.25%. After 25 years, that same $25,000 will grow to $143,838.

Rebalance your asset allocation and you might earn an extra $8,000 for retirement, on your $25,000 investment. And that’s why you want to rebalance.

All About Asset Allocation

Asset allocation is the percent of your total investable money you direct into specific investments.

Diversification or asset allocation is described by the adage, “Don’t put all of your eggs in one basket.” Diversification of your financial assets (stock funds, bond funds and other financial investments) is the best way to boost investment returns and reduce risk.

As a reminder, you invest in the stock market because over the past hundred years or so, stock market investments averaged approximately 9.0% or so per year. Then you add in bond funds, because, although their returns are typically lower than stocks or approximately 5.0% annually, they don’t have as much risk, or investment volatility.

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In this next example you’ll view the returns of each asset class along with a stock and bond combined portfolio. We allocate 65% of the whole into the S&P 500 (a proxy for the U.S. stock market) and 35% into the 10 Year Treasury Bond (a proxy for the U.S. bond market).  

Asset Allocation Caution

Be careful when looking at “average” returns. Look at the annual return chart below and you’ll notice several negative return years for your investment in the S&P 500 and a couple negative years for the 10 Year Treasury Bond.

This next example isn’t an attempt to scare you, but a realistic picture of how investment class returns vary from year to year. The chart below shows annual returns for stocks, bonds and a 65%:35% mixed portfolio during various time periods.

historical-financial-asset-returns_2016

What if you started investing in 2000?

During the first three years of the decade, the stock market returns were negative, -9.03%, -11.85%, and -21.97%, respectively. Yet, if you had an asset allocation that included 65% stocks and 35% bonds, your overall investment returns would have been better than the all stock portfolio-although still in negative territory.

For this one year investing example, imagine that you start out the new millennium with a $1,000 investment.

Invest it all in stocks (S&P 500 index fund) and at the end of the year your $1,000 is worth $903. Invest the $1,000 in 10-year treasury bonds and at the end of the year, your money is worth $1,017. It would have been great to be all in bonds in 2000, but the problem is that at the beginning of the year, you don’t know the future direction of the stock and bond markets.

For long term investors, it’s clear, your returns in all of the asset classes were positive.

Asset Allocation Protects Against Future Market Uncertainty

The uncertainty of the future is why you set up an asset allocation. An investor moderately comfortable with risk might invest 65% in stock funds and 35% in bond funds. With several decades until retirement you figure this asset allocation seems about right.

Modern investing portfolio theory recommends determining your risk profile and then divvying up your portfolio in line with your risk level. In other words, if you can handle a bit more volatility in your investment returns, you want more stocks in your portfolio. Terrified of the cyclical ups and downs in your investment value, invest a greater percent in bonds.

Asset allocation is the investors personal decision about how to divide up your investments among basic asset classes. In general, investors divide their assets between stock and bond type investments. Younger folks, with more time until retirement and a longer working life ahead frequently benefit from an asset allocation more heavily weighted toward stock investments.

A guy in his 50’s facing retirement in fifteen years and risk averse, may choose 55% stock investments and 45% bond investments. A young woman with a high paying secure job and a high-risk tolerance chooses 75% stock investments and only 25%

 

Learn how to rebalance your asset allocation for better returns with less volatility

 

How to Rebalance Your Asset Allocation and Increase Returns

Next, you’ll meet Carter and learn exactly how this 39 year old rebalances his asset allocation.

Asset Allocation of a Moderately Aggressive 39-Year Old

Following is a description of 39-year-old Carter’s, moderately aggressive $10,000 investment portfolio-66% stock funds and 34% bond fund:

  • $3,300 – 33% in a broadly diversified United States stock index fund
  • $3,300 – 33% in a broad diversified International stock index fund
  • $3,400 – 34% in an inflation protected bond fund

Carter’s asset allocation is equally divided among three mutual funds.

How to Rebalance Your Asset Allocation-Step 1

First, tabulate the value in each of your asset classes.

Assume that during a fictional year, the U.S. stock market increased 9% so Carter’s U.S. stock index fund increased to 34% of the overall portfolio. With the economic troubles in Europe, the international fund fell 5%. Finally, with the decline in market interest rates, the inflation protected bond fund increased in value 13% and grew to 38% of his total investment portfolio.

After one year, due to changes in of U.S. and international stocks and bonds, the value his portfolio was $10.574.00 for a total gain of 5.7%.

  • $3,597.00 – 34% in a broadly diversified United States stock index fund
  • $3,135.00 – 29.6% in a broad diversified International stock index fund
  • $3,842.00 – 36.3% in an inflation protected bond fund

The goal of rebalancing is to return the proportion invested in each asset class to your original percentages; 33% in the each of the stock funds and 34% in the bond fund.

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How to Rebalance Your Asset Allocation-Step 2

Before rebalancing, you need to know your current asset allocation.

Here are the steps to figure out your asset allocation:

1. Sum your entire investment portfolio value.

2. Divide the amount in each asset class by the value of the total portfolio and multiply by 100.

That is your current asset allocation.

Next, figure out how to rebalance to your target allocation.

3. To return to your target asset allocation, multiply the total value of the portfolio by the target asset allocation percentage. For example, for the stock fund multiply .33 by $10,574.00 and you have the targeted value of that asset class of $3,489.40. Continue for each asset class.

4. Subtract the value after year one from the value at the target asset allocation to arrive at the amount to buy or sell. For the stock fund, subtract $3,597.00 from $3,489.40 and you determine that you need to sell $1,076.00 worth of the stock fund.

How to rebalance your asset allocation steps

Now you know the exact dollar amount of each fund to buy or sell, in order to return to your targeted asset allocation.

How to Rebalance Your Asset Allocation-Step 3

When considering how to rebalance your asset allocation, there are several alternatives to rebalancing.

1. You can sell off the assets which have increased above the target level and buy more of those that are beneath the target. In other words, you would buy $354.42 more of the International stock index fund and sell $107.58 worth of shares of the U.S. stock fund and $246.84 of the bonds, so that the percentages return to the original proportions, as shown in the value of the target asset allocation row.

2. Another option is to invest new monies into the asset class or fund that is below the target. In this case, it’s the International stock index fund. That way the International stock index fund would increase as a percent of the total portfolio until returning to the desired allocation. This is an easy way to rebalance funds in a 401(k), by directing new contributions into the investment that’s declined from its original allocation percentage.

3. If your allocation is off by a small amount, like in the stock fund, you may choose to do nothing. After all, each day, when investment prices change, your asset allocation will also change.

When rebalancing your asset allocation, don’t worry about perfection, just move towards the general direction of your preferred asset allocation.

How Often to Rebalance Your Asset Allocation?

Rebalancing once or twice a year is enough. It’s unnecessary to undergo rebalancing more frequently. The reason for rebalancing is to buy low and sell high. The investments that have fallen in value are bought (buy low) and those that appreciated are sold (sell high).

Personally, I check both my own portfolio and those that I manage several times per year, but rarely rebalance more than once per year. The research supports rebalancing once or twice a year is likely to boost returns about .25%.

Is it worth an hour or so to increase returns and reduce your portfolio’s ups and downs?

How often do you rebalance? What are your investing thoughts?

A version of the article was previously published.

 

    15 Comments

  1. I usually review my asset allocation every December to see if I want to rebalance. Thanks for the reminder.

    krantcents

    November 26, 2012

  2. Interesting that you rebalance so infrequently @Barb and @Krant even more so! We will shortly be starting an investment campaign so I have been watching how people do it.

    John@MoneyPrinciple

    November 27, 2012

  3. We typically rebalance once a year. I check in on it several times a year and usually only make changes annually. That’s a pretty good percentage, and knowing that it convinces me even more of the need to rebalance.

    John S @ Frugal Rules

    November 27, 2012

  4. @Krantc, John, and John, If you set up a simple portfolio populated with 2-4 index funds in your preferred asset allocation, management is so easy. And, your returns will beat the majority of actively managed mutual funds.

    Barb

    November 27, 2012

  5. I admit I’ve never rebalanced, yet my funds have never gotten too many % points away from my ideal allocation. This is something I look at each year, but I’ve never pulled the trigger.

    Brent Pittman

    November 27, 2012

  6. @Brent-I’m glad you shared this information. If your percentages stay within a point or three of your initial allocation, no need to rebalance!!!

    Barb

    November 27, 2012

  7. I totally concur Barb. Your point about risk is a key one in talking about rebalancing. I stress to my clients that we need to consider risk first and that is the main reason for asset allocation/rebalancing.

    Roger Wohlner

    November 27, 2012

  8. @Roger, I always appreciate your comments and insights. Your volatility is moderated with a well diversified portfolio.

    Barb

    November 27, 2012

  9. Rebalancing is so important. Just because a fund did well this year doesn’t mean that it will be great next year and vice versa. By buying a less liked asset class you can buy more shares at a lower price.

    Justin@TheFrugalPath

    November 27, 2012

  10. Funny. When “Bloomberg” had a magazine they called rebalancing the toughest thing to do in investing….because you had to sell your “winner” and move the money to a “loser.” Just getting over that hurdle is difficult for most people, but as you show, totally worth it!

    AverageJoe

    November 28, 2012

  11. @Justin, Actually the research bears out the fact that in most cases, fund returns revert to the mean and winning funds usually underperform the next year.
    @Joe- It is really difficult-even for those who know the importance of rebalancing. And btw, Bloomberg still has a magazine; Now it’s called Bloomberg Businessweek (and it’s issues are piling up in a corner of my family room, no matter how fast I read 🙂 )

    Barb

    November 28, 2012

  12. I agree rebalancing does not have to be hard. I also have seen the data that validates properly diversified passive ETF strategies are a good bet for most long term investors. Full disclosure, I am the CEO of a data analysis tool that see this first hand. We use crowdsourced data that allows individuals to see exactly how their returns, asset allocation and fees differ from top performers. This is often the most difficult step in deciding to rebalance. Answering the “What should I rebalance to?” question. We make that part easy and take away all the second guessing.

    Jason St Peter

    June 11, 2015

    • Hi Jason,

      Thanks for stopping by. I certainly agree with the idea that “properly diversified passive ETF strategies” are a sound (and low cost) investment approach for most! Looking forward to the progress of your Draftapp tool.

      Barbara Friedberg

      June 12, 2015

  13. I agree but find it much more complicated now I have so many funds and I don’t have the confidence or knowledge to slim down the portfolio to less funds as it was originally built by an advisor

    Paul

    February 26, 2017

    • Hi Paul, With more funds, it’s a bit trickier to rebalance. If you aren’t comfortable with the funds in your own account, it’s probably time to understand what you’re invested in and whether you want to keep your existing funds or adjust. I’d recommend two books to help you get started: The Elements of Investing by Malkiel and Ellis and my own Invest and Beat the Pros-Create and Manage a Successful Investment Portfolio (http://amzn.to/1Hh1ZpB). Good luck!

      Barbara Friedberg

      February 27, 2017

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