Chapter 7
Rebalancing

Rebalancing is the rather simple but important process of resetting your asset levels back to their original percentages (allocations). You will need to do this once or twice a year as some assets will gain faster than others or some may lose ground.

John Brennan says in Straight Talk on Investing "People tend to think about investing only in terms of making money. Making money is why we invest, but the reality is that if you don’t remember to manage risk along the way, you won’t do well at making money."

That is a very important statement. Keep risk at the level you originally decided it should be. As assets grow, your stock allocation will become higher than you originally intended. There may be a temptation to let it ride, but this increases your risk, which you have carefully evaluated in your asset allocation model.

In down markets your stock allocation will shrink. You may find it tough and counter to reason to add money to losing assets, but this is a way of buying when stocks are cheaper. Rebalancing in down years forces you to be a bit of a contrarian investor—one who doesn't follow the crowd. This strategy can provide a bit of a return bonus and keep volatility in check over time.

There are several methods used for rebalancing,¹³ but it's not critical that you follow an exact formula. Check your allocations once a year to see if the primary allocations have changed by more then 5% and watch smaller allocations to volatile asset classes to see that they haven't gotten too far off the target. If you are adding new money on a regular basis, you can allocate it where needed to adjust to your targets.

Here are some general rules for rebalancing from author Larry Swedroe;

1) the main thing about rebalancing is the discipline of buying low and selling high, and restoring the risk profile.

2) you must consider costs of rebalancing (taxes and transactions costs) in taxable accounts as they will impact the frequency and timing of rebalancing.

3) rebalancing should always be done whenever you have new dollars to invest (no tax implications).

4) rebalancing can be done more frequently and more tax efficiently of course in tax deferred accounts.

5) given the evidence of short term momentum, it may not be best to rebalance too frequently (let the winners ride for short time, but not too long) . But again risk control is biggest issue to me—not returns.

6) once per year if you don't have cash is fine—but even then I wouldn't do it unless you had significant style drift"

Mr. Swedroe advocates what he calls the 5/25 rule. When a major asset moves more than 5% off target, it’s time to rebalance. Example: Your asset allocation is 70% stock/30% bond. If equities grow to be 75%, then it’s time to rebalance.

If the an equity asset is 25% or less than total equity, then you use the 25% trigger. For instance, if you have 10% REIT, then the rebalance points would be plus or minus 25% of 10, which = 12.5% and 7.5%. Rebalancing at this level would not be critical for bond holdings.

Rebalancing isn't difficult, but it is important and part of your investing discipline.

Note 13: Walter Updegrave, "Rebalancing Act," 11/2003, www.money.cnn.com

On to Chapter 8