Rules-Based Rebalancing

Rebalancing is a critical element of asset allocation and risk management. It helps ensure that your portfolio reflects your needs and goals, and it provides a systematic means to "buy low and sell high." Most importantly, rebalancing helps you avoid the bubbles that invariably afflict the stock market and invariably burst, creating pain as prices and account values plummet.

Consider this very simple example:

Let's assume you have a moderate portfolio composed of 60% US stocks and 40% US bonds and that appropriately reflects your risk tolerance and time horizon. (Keep in mind that I would never recommend such a portfolio because it is not sufficiently diversified.) After a couple of years, stocks have significantly outperformed bonds, and your portfolio now looks like the image on the right with a 70% allocation to stocks and only 30% in bonds. The good news is that you've made money in stocks, the bad news is that your portfolio is now riskier than what you had targeted with the original 60-40 allocation. The smart thing to is to reduce your stock position (sell high) and increase your bond position (buy low).

There are two common approaches to rebalancing:

* Calendar-Year Rebalancing: This is the most widely used approach. At predetermined times, usually annually but sometimes quarterly, the portfolio is rebalanced back to the original allocation percentages.

* Rules-Based Rebalancing: This is usually a better approach to rebalancing, though it requires more diligent monitoring of the portfolio. When the portfolio allocations are determined, a "rebalancing threshold" is also established and rebalancing occurs whenever that threshold is hit. For example, if a particular asset class comprised 10% of the original portfolio allocation the thresholds might be set at plus-or-minus 2%. I other words if, because of market action, the asset represents less than 8% or more than 12% of the portfolio, you would rebalance the entire portfolio back to the starting point, not just the one asset class in question.

Rebalancing is a must in non-taxable, qualified accounts like 401(k)s and IRAs. However, you should consider the tax implications of rebalancing before making trades in taxable accounts.