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During the building of my dividend based investment portfolio, I have strived to ensure that I have a well-researched and sound asset allocation. With that complete, the next step of effective portfolio management is the act of rebalancing. In this post, I am going to explain what rebalancing is and how I like to use it in my own personal portfolio.
Rebalancing is the act of boosting underweight asset classes and trimming overweight asset classes in a portfolio. It’s primary purpose is to bring your actual portfolio characteristics in line with your solid and well-researched target asset allocation. For example, let’s say that you have a target asset allocation of 40% Domestic Equity, 30% Global Equity, and 20% Fixed income. Over the course of a one year period, the markets have ebbed and flowed at times mildly and at other times dramatically. At that one year period, your portfolio asset allocation now is 20% Domestic Equity, 50% Global Equity, and 30% Fixed Income. Your actual asset allocation is now significantly off your target allocation. A careful investor would take the steps necessary to rebalance the portfolio by buying (or selling) assets to once again meet your target allocation. The reason for this rebalancing is all about managing risk.
Regardless of what asset allocation you have chosen, the primary purpose of asset allocation is to manage the risk-and-reward profile of a portfolio. A well-constructed asset allocation can effectively provide higher returns with much less risk. With a portfolio that is out-of-whack, then the investor is open to much more risk and perhaps poorer returns.
So when and how often should an investor rebalance? That entirely depends on how you elect to manage your portfolio and how comfortable you are with higher risk. If you are a very conservative investor with little tolerance for risk, then a quarterly rebalancing strategy may be an ideal strategy. If you are comfortable with more risk and like a more hands off strategy, then an annual rebalancing strategy may be best for you. One important thing to keep in mind when deciding on your strategy is to consider the tax implications of the rebalancing. If your assets are in a tax deferred account, then more frequent rebalancing is not an issue as it does not create any tax implications. However, if you have assets in a taxable account then careful consideration must be given to your portfolio actions. Taxes can eat up a big chunk of money!
My rebalancing strategy tends to be a bit more frequent, simple because I add to my investments on a monthly basis and keep my asset allocation in line by more often than not adding to positions rather than selling them. Each month I see where my asset allocation is and decide where to allocate my incoming investment money. This has allowed me to limit the selling in my account and to more frequently keep my asset allocation in line.
I would love to hear your asset allocation rebalancing strategy. Do you buy or sell dividend stocks or other assets quarterly, semi-annually, or annually? Do you rebalance at all? Let me and other readers know by using the comment section below.
TDG,
This is a very intriguing article. Have you found any studies that prove that maintaining asset allocation underperforms/outperforms not rebalancing at all?
It would have been a terrible idea to keep a mix of stocks and bonds properly balances in the 1990’s, yet in the early 2000’s it would have been a genius idea.
You are correct however that holding your investments in a taxable account would be a very expensive approach in retirement. What would be a “perfect world” scenario?
I myself would not sell a stock simply because I am overextended to a certain sector or a certain stock has risen so much that it represents 5% or more of my portfolio. Since I am still in my accumulation phase, I might simply direct new funds towards other companies or keep them in cash if I don’t see anything interesting.
Given I like to hold these stocks for a very long time, I like to rebalance every 12-18 months. I’ll only do it sooner if something really strange happens in the market. For example, many energy stocks have increased very quickly given the craziness with the price of oil. Taking some profits and rebalancing makes a lot of sense in that case. I also reinvest the dividends and use that as a way to rebalance if needed.
I rebalance my 401k every 12 months. When I rebalance I normally sell of some stock in order to buy another to meet my asset allocation goals.
I also make sure that the contributions from my pay check match the asset allocation that I wish to keep. I normally update the my paycheck allocation at the same time that rebalance my 401k account.
As I am in the current process of developing a non-401k portfolio that has different and shorter term goal (ie saving up to buy a house in 3 to 5 years). I am kind of building this as I go so right now I am buying stocks every month that are setting up my asset allocation goals.
Here is the run down that I use.
My wife’s 401K matches 100% so hers is in safe low growth investments because we are getting 100% return plus the return on her investment.
My 401K only matches 25% so I am more into international, and world funds along with bonds, and total return funds. On mine I watch it on the web and make changes in investment strategy about every 6 weeks if needed, but that is only to change where I’m putting my allocation because I still have 17 years till retirement for any bounce back that I may need.
With the direct purchase plans that I’m in I have $250 a month that I put into the market that I can invest into up to 5 companies. My choices here at this time are the following companies.
(BAC, PFE, FRAF, LBY, DBD, PEP, K, XOM, MSFT, VZ, CVS, GE, WMT)
I also have the following options with companies that I own stock in I am not sure if they have DSPP but the do offer DRIP’s and they are (DOW, and UGI)
As you can see with 15 companies to choose from I have no problem diversifying my picks. As you stated this is for the long haul. I’m just trying to build positions in these companies slowly and rolling over dividends and who knows in 17 years I might not be putting cash into them each month but the dividends can keep building my position or they could be a supplement to retirement.
Bob,
I thoght that DBD is getting taken over. Isn’t it time to sell it and move on?
Great article, you just reminded me that Its getting close to rebalancing time for me again. One thing I’d like to add, is when I go to rebalance, I like to take a quick look at the technicals of a stock before I move some money out of a position. For example, if the stock in question is currently enjoying a bullish run up in price, then I’ll hold off on the rebalancing efforts (for this stock) until it is finished its run up. Sometimes this delays things a few days or weeks, but I think its definitely worthwhile.
Rebalancing has really paid off for me this year. My strategy is to rebalance twice a year, and when things get really out of whack. This year with gold climbing hard, gold triggered a “really out of whack” sell event and I sold a large gold position that got dumped into the other assets. Two days later gold peaked and started to decline and is has not quite triggered a “really out of whack” buy event.
The “really out of whack” principle has allowed me to take advantage of really big, unexpected moves, while not chasing (and therefore missing) them.
Within my RRSP with Manulife, I am able to trade between funds in the plan without charge so I rebalance monthly when any category (Bond, Canadian equity and Foreign equity) gets more than $1000 out of line with my allocation. When things are not volatile, I can go months without a change. In recent months, I have frequently had to buy and sell.
I rebalance when the targets are out of balance by +/- 35%. Using data from eight asset classes dating from 1989 – 2007, 35% is the optimum rebalancing point, assuming one does it once a year.
In reality, I’ve found that one can keep a portfolio in balance by taking dividends and reinvesting them in the asset classes that are below target. This has been working for a portfolio that was set up nearly eight years ago.
Physlab