Last Updated: January 30, 2009
In the old days, your financial planner and you would go through the process of stating your time horizon, determining your risk tolerance and identifying your investment objectives before establishing your asset allocation — what percent of your money you would invest in stocks, bonds and cash. You would then read just that mix according to some pre–defined set of rules – once per year or whenever the mix was out of balance by five percentage points or so.
But 2008 wreaked havoc on the act of rebalancing investment portfolios. Consider, for instance, a hypothetical $100,000 portfolio that began in 2008 with 60 percent invested in stocks (the Standard & Poor's 500 stock index) and 40 percent in bonds (a U.S. aggregate bond index). According to Ibbotson Associates and Morningstar Direct data, the stock portion would have declined 37 percent, turning $60,000 into $37,800 by the end of 2008 and the bond portion would have risen 5 percent, turning $40,000 into $42,000. The net result being a portfolio worth $79,800 at the end of 2008, with a 47 percent in stocks and 53 percent in bonds. Assuming no major changes to this hypothetical person's life, that portfolio is clearly in need of rebalancing. In the old days, the financial planner might typically sell about $10,000, or 13 percentage points, of the bond portfolio and invest that amount back into the stock portfolio.
"But times are different now," said FPA member Lyman H. Jackson, CFP®, MBA, of Jackson Financial Advisors. "This is a difficult question especially in these times when investors' portfolios are typically out of balance because of 1) the market decline's effect on the equity portion of a portfolio and 2) some investor's portfolios were out of balance before the decline."
So what should you do? Well, if your portfolio was in balance at the start of 2008, Jackson recommends that you simply rebalance the old–fashioned way–trimming here and adding there to get back to your target asset allocation. "Rebalancing is a foregone conclusion in order to keep one's investments on track," she said.
However, if you are among those investors whose portfolio was never in balance at the start of 2008, you have your work cut out for you. First, you need to identify the reasons why your portfolio was out of balance and then you need to examine what, if anything, has changed since you last established a target asset allocation.
Some investors, for instance, let their emotions dictate their asset allocation instead of their plan. "One of the primary reasons why investors let the percent invested in stocks get too large is the overconfidence that accompanies a bull market," Jackson said. "If you're among that group of investors who confused brains with a bull market, it might be time to let your plan dictate your actions."
If you among those whose circumstance has changed, it might be time to consider other types of assets or products to accomplish your investment objectives. If you're a pre-retiree for instance, it might be time to think "outside the usual rebalancing box," Jackson said. In some cases, it might make sense to reduce the percent invested in stocks and increase the percent invested in bonds and guaranteed investments such as certificates of deposits (CDs) or annuities. "The tricky part is to not rebalance so much that you set yourself up to get whip-sawed in the process," she said. "You don't want to miss rebounds when they occur."
Another way to rebalance is to take advantage of dollar-cost averaging, the process of investing a set amount of money at regular intervals. Contributing to your 401(k) plan is an example of dollar-cost averaging. "One of the best ways to smooth out the risk especially in markets that are volatile day-to-day is to dollar-cost average towards the appropriate asset allocation over six to 12 months," Jackson said. Take for instance the hypothetical portfolio from above. Instead of selling $10,000 in bonds and investing that amount in stocks, you would simply invest 100 percent of you regular contribution into stocks until your portfolio was rebalanced back to its target asset allocation.
"This is a sensible strategy for many because it takes the timing question out of when to rebalance," Jackson said. "At the same time, the investor is not as worried about rebalancing all on what could turn out to be the wrong or worst day of the year."
