When should you Rebalance?

Let's assume that -- because of your personal and financial circumstances -- you decide to allocate your investment assets as follows: you want fifty percent of your portfolio in stocks, forty percent in fixed-income investments (bonds), and 10 percent in cash equivalents. So, you build your way into such a portfolio using dollar cost averaging; investing gradually, perhaps over two- to three years.

After your portfolio is set up, some more time passes, maybe a few months. The stock market has risen and the bond market has declined somewhat. You're now holding sixty percent of your portfolio in stocks, thirty percent in bonds, and ten percent in cash. Your asset allocation is now riskier than you'd originally intended.

What do you do? Should you follow the 'buy and hold forever' strategy, riding your winners and keeping your current asset allocation? Or should you backtrack to your previous positions, selling enough of your stocks to get you down to fifty percent, and adding that to your fixed-income investments, bringing that percentage back up to forty again? Or yet again, should you put additional money into your winners, investing more into your stocks and less into bonds? You know the old adage: the trend is your friend.

But perhaps you shouldn't wait for a significant imbalance to occur; would it be better to automatically rebalance your portfolio at regular intervals?

Certainly, there's no hard and fast answer to any of these questions. Individual goals, personalities, situations and circumstances must be weighed in every decision. Basic sensibilities, however, would seem to suggest that the most prudent thing to do would be to rebalance whenever your portfolio gets substantially off-center, or exposes you to more risk than you're willing to take. In doing so, you reap the added benefit of locking-in your gains by selling whatever has gone up dramatically, and you're also able to buy other securities at a cheaper price.

As a matter of fact, studies have shown that rebalancing a portfolio when it's a good distance away from its original position seems to work best. Various types of rebalancing techniques were followed over three-, five-, ten-, fifteen-, and twenty-year periods. The most profitable was rebalancing when there was a 7½ percent to 10 percent misalignment. Over all of the investment horizons, this strategy performed better than annual rebalancing. However, if you do choose to follow a preset-time strategy, rebalancing quarterly or semiannually is probably too frequently; the annual rebalancing strategy will likely give you the best result.

In most cases, the investor would be well-served to rebalance only when his or her portfolio reaches a predetermined level of risk exposure rather than to make the adjustments on a calendar basis. This has the advantage of producing a narrower range of possible stock weights and also, in most cases, requires fewer rebalances.

Experienced investing consultants recommend rebalancing a conservative portfolio yearly, a moderate portfolio every six months, and an aggressive portfolio every three months. The logic seems to be that aggressive portfolios get away from their original positions faster than do conservative ones. While that may be true, a case also can be made for the reasoning which says, the more conservative you are, the more frequently you should rebalance, in order to keep your portfolio stable and in line with your investment goals.

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