Investors’ New Year’s resolutions often include a vow to pay more attention to rebalancing — making sure the mix of stocks, bonds and cash actually matches the plan.
And the process is easy in January, thanks to year-end statements that clearly show how each holding has done over the past 12 months. If your stock and bond split has grown to 70-30 and your target is 60-40, it might make sense to sell some stocks and buy bonds
But financial advisors say rebalancing is like dieting and exercising — too easy to put off.
“Clients make the same mistakes rebalancing their portfolios as they do in all other types of investing,” says Brannon Lambert, an advisor with Canvasback Wealth Management in Raleigh, North Carolina. “They hold on to winners trying to let them run before taking profits, and they sell the positions that are down in the portfolio and move the money to investments that went up, buying high and selling low.”
[See: 10 of the Worst Performing Stocks of 2016.]
Why rebalance at all? Doesn’t getting off target just mean one class of holdings has done especially well?
No, it could mean one or more have done poorly. Either way, the asset allocation is designed to provide the best combination of risk and potential reward. Allowing the stock portion of a portfolio to get much larger than intended means taking more risk, while too much in bonds could stunt growth.
So keeping on target makes sense — so long as the goal doesn’t take the place of judgment, says Robert Johnson, president of the American College of Financial Services in Bryn Mawr, Pennsylvania. He says, for instance, that stocks have been on a run recently while long-term bonds have been hammered by Federal Reserve plans to raise interest rates, which can be expected to drive bond prices down. But robotically selling stocks to buy bonds could be counterproductive, he warns.
“That is asking someone to sell an asset that has been outperforming to buy one that is definitely going to face headwinds next year” as the Fed raises rates, he says in a blog. “Over the long term, re-balancing is definitely a wise move to make, but blind adherence to any rule is problematic.”
So experts recommend investors start the process by making sure their targets make sense, while avoiding taking automated advice too literally. Many investors settle on an allocation with an online tool provided by their mutual fund company or brokerage, and these programs cannot account for the fine points of a single investor’s situation.
Two investors of the same age and assets, for instance, could have a very different tolerance for risk if one could count on a traditional pension and the other couldn’t. One investor might expect, given health and family history, to live to 100, while the other might be ailing. The first might want a riskier portfolio full of stocks aimed at growth, while the second might prefer safe bonds to hang on to what he has.
Also, many risk assessments ask questions like whether you would buy, sell or hold if your stocks lost 10 percent or more. Answering “sell” could tell the program you have a low risk tolerance and the software might advise fewer stocks and more bonds. But a human advisor might say you are worrying too much and recommend standing firm, as 10 percent corrections are routinely reversed.
Experts have a number of tips for successful rebalancing.
Be resolute. Investors are often reluctant to rebalance because it means selling a successful holding to buy one that has lagged. But studies show that this works over time if combined with sound judgment. A stock or fund that has soared may be ripe for a fall, and the laggard may be ready for a run.
Rebalancing should include a reassessment of everything you own, not just the broad asset classes. With each holding, it pays to ask, “Would I buy it today?” If you would, keep it. If not, let it go.
[See: 9 Psychological Biases That Hurt Investors.]
A winning investment that still has good prospects should not necessarily be trimmed just to restore the desired asset allocation. “You won’t earn 1,000 percent anytime soon by selling your best investments every year,” says Chris Georgandellis, founder of Tree Town Investments in Ann Arbor, Michigan.
Don’t be too literal. If rebalancing makes sense when you’re off target by 10 percent, wouldn’t it pay to get a jump on things and do it when you’re off by 1 or 2 percent?
Probably not, because small fluctuations are so common that a little adjustment today might have to be reversed tomorrow. It’s a hassle and could be counterproductive if it means triggering commissions or tax bills that could be avoided.
Following a calendar works for people who prefer that kind of deadline, though December makes more sense than January because it allows time for tax-loss selling, Georgandellis says. But he prefers to rebalance whenever allocations drift far enough off target.
“When monitoring client portfolios, I often set 5 percent in one direction as my on-notice warning, and 10 percent as the hard line where I act to fully rebalance a portfolio,” he says.
Lambert says, “We look for a move of at least 25 percent from the target allocation. If we have an allocation to an investment of, say 15 percent, then we look to take action on that holding when the weighting becomes below 11.25 percent or over 18.75 percent of the overall portfolio.”
Take it slow. If you’ve waited a long time and have to make a big adjustment, it might be best to do it in stages over a few months. That way there’s less risk of picking the wrong day — selling one asset after it dips and buying another after it jumps, for instance.
Another approach: rebalance over time by changing the purchases made automatically through your 401(k), or any other account to which you make regular contributions.
“If you make systematic contributions to your portfolio do not automatically invest the money in every fund in predetermined percentages,” Lambert says. “Instead allow the cash to build up during the quarter then make strategic decisions on where best to allocate the funds.”
Be tax efficient. Another reason investors drag their feet with rebalancing is the dread of tax bills for selling winners. Those can be avoided by making changes in tax-favored accounts like 401(k)s and individual retirement accounts. So long as the portfolio as a whole meets the target allocations, it’s not necessary for each account to have the same mix, Georgandellis says.
“While much attention is paid to asset allocation, very little is paid to asset location,” he says. “For example, many people will maintain a 70-30 allocation to stocks and bonds across their accounts. A more efficient allocation would place stocks in a Roth IRA, bonds in a traditional IRA, and leave the stock-bond split to a taxable account.”
[See: 7 of the Best Stocks to Buy for 2017.]
That way, the stock gains in the Roth could avoid taxes entirely, bond interest in the IRA would be tax-deferred until withdrawal, and capital gains in the taxable account could go untaxed until holdings were sold. Meanwhile, selling losers in the taxable account can help reduce capital gains and income taxes, Lambert adds.
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