How to Rebalance Your Investment Portfolio

Rebalancing your investment portfolio is a critical component of investing. Any finely tuned asset allocation, as asset prices move up and down, will begin to deviate from your investment plan. How to rebalance your portfolio is the easy part, which we’ll get to in a minute. But first let’s talk about the difficult part of rebalancing.

Let’s assume you have an asset allocation of 70% stocks and 30% bonds. Let’s also assume that stocks have been going through the roof while bonds have been crashing, such that over the course of a year, stocks now comprise 85% of your portfolio, and bonds just 15%. To rebalance, you’ll need to sell 15% of your stocks (which have been going up) and buy 15% of bonds (which have been going down). Emotionally, that’s not so easy to do. But in the long run, rebalancing will enable you to achieve the investment goals established with your initial asset allocation plan.

And that brings us back to how you rebalance your portfolio. Recently I’ve had to spend some time with our investments, which had deviated significantly from our asset allocation plan. First, here’s a quick pie chart showing our target asset allocation:

Target Asset Allocation

Target Asset Allocation

Our asset allocation plan is similar to that recommended by David Swenson, who manages Yale’s endowment fund. We have made some changes. For example, he recommends a portfolio of 20% real estate. Because I invest in rental properties, however, I’ve reduced that percentage in my investment portfolio to 10%. The difference I’ve added to foreign developed market equities and emerging markets. You can learn more about how to structure your own investments in a series of articles on how to create an asset allocation plan.

Our actual asset allocation, for lack of rebalancing in more than a year, has deviated substantially form this plan. Our domestic equity investments have grown to about 50% of the total portfolio, while foreign investments of shrunk. To give you an idea of where we are, here are the mutual funds and stocks we own, along with the percentage of invested assets in each fund:

Fund/Stock Ticker Asset Class %
Fidelity S&P 500 Index FUSEX Domestic Equity 27%
Bridgeway Ultra-Small Company Market BRSIX Domestic Equity 4%
Dodge & Cox Stock DODGX Domestic Equity 7%
Allianz NFJ Small Cap Value Instl PSVIX Domestic Equity 9%
Berkshire Hathaway BRK.B Domestic Equity 2%
Dodge & Cox International DODFX Foreign Developed 8%
Fidelity Diversified International FDIVX Foreign Developed <1%
Fidelity International Real Estate FIREX Real Estate 2%
Vanguard REIT Index VGSIX Real Estate 5%
Fidelity International Real Estate FIREX Real Estate 2%
Vanguard Emerging Mkts Stock Idx VEIEX Emerging Markets 9%
Vanguard Inflation-Protected Secs VIPSX TIPs 7%
Templeton Global Bond A TPINX Bonds 8%
PIMCO Total Return Instl PTTRX Bonds 13%

So what are the steps to rebalancing. In part because some of my investments are in taxable accounts, here are the steps to take to rebalance this portfolio:

Step 1– Change contributions: The starting point is to make sure your current contributions are going to the asset classes that are in need of additional investments. In my case, I had been contributing all of my 401(k) contributions to the Fidelity S&P 500 Index fund (FUSEX). As a result, that fund has substantially more assets that called for by our asset allocation plan. So I’ve redirected current contributions to a foreign developed market fund.

In some cases, simply redirecting current contributions may be all that’s needed. I’ll be opening an SEP IRA at an online discount broker (probably Scottrade) this month, and can use the contributions to this account to further adjust my asset allocation. Even with the SEP IRA, however, the allocation of investments need additional corrections, which brings us to step 2.

Step 2–Redistribute investments among retirement accounts: Buying and selling funds within a 401(k) or other retirement account generally doesn’t have any tax consequences. Remember that these funds are tax deferred until you withdrawal money. So I can buy and sell any fund within my 401(k) without worrying about paying taxes.

For my investments, I’ll be selling a portion of FUSEX and using the funds to buy into asset allocations to align my investments with my asset allocation plan. This will primarily involve buying more foreign developed market shares.

Step 3–Redistribute investements among taxable accounts (if necessary): Only as a last resort will I buy and sell funds in my taxable account to rebalance. Because selling funds in a taxable account does have tax consequences, I try to avoid this at all costs. Here, I should be able to come close to my asset allocation plan without taking this third step.

One final thought. We have four retirement accounts–three at Fidelity and one at Vanguard. Two of the Fidelity accounts are 401(k) plans from prior employers. I plan to roll these over into the Vanguard account as part of my rebalancing. Why? Vanguard offers better funds at lower prices, in my opinion. The result will be that it will take fewer funds to achieve my asset allocation, and the cost of the funds will come down, too.

Topics: Investing

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