It is very important to rebalance your portfolio periodically. Whether it is a normal “taxable” account or an IRA or 401k, you or your investment manager should look at it every year or even every 6 months to see if your investment allocations are out of whack. This takes discipline. Maybe you look at it January 2 (first day of trading for the New Year), or every year on your birthday, but however you remember it, you should rebalance at least every year.
Process
Most successful investors have a process for deciding on allocating a portfolio. Basically, the process is this:
1) Decide on an allocation that is right for you based on your age, years to retirement, investment objectives, or the type of account that it is;
2) Allocate your portfolio according to how you have decided; and
3) Check to see if your allocation remains in line, and if not, rebalance it by selling part of the over-allocated portion and buying the under-allocated portion.
A simple allocation objective might be something like 60% equities and 40% bonds. A more sophisticated objective, especially if you are younger, might be 25% large cap stocks, 25% small cap stocks, 25% international stocks, and 25% bonds. In a 401k or similar retirement account, your ability to allocate might be limited by the mutual funds that you have available to invest in. In this case, you look at your set of funds available to invest in and you choose and allocate among them. Typically you can still have some sort of stock/bond percentage allocation.
Many investors are good at Steps 1 and 2 above but they fall short at Step 3 because they forget or they are not disciplined enough to reallocate.
Out-Of-Balance
Once allocated, how does the allocation objective get out-of-balance? Because of different investment results. Say you have allocated 60% to stocks and 40% to bonds. Then, over the ensuing year, stocks go up 10% and bonds go up 2%. That would be a good performance! However, at the end of that year, because stocks have gone up more than bonds, you are now over-allocated to stocks. If you have continued to contribute to the account during the year, that is good, but typically your new contributions will be allocated in the same 60/40 manner. Your new contributions will help your account balance go up, but it won’t change your out-of-balance problem. At the end of that first year, you need to sell stocks and buy bonds so that, for the start of Year 2, you are now back in line with the 60/40 split.
Why?
Why is it important to reallocate? Because of mean reversion, and because you are now one year older and closer to retirement. Just because stocks may have outperformed this past year doesn’t mean they will outperform for the next year. Stocks may very well hit a rough patch and bonds may outperform next year. As you grow older, your allocation toward bonds and away from equities risk should increase. If you are more exposed to stocks now than you were a year ago, you need to correct it. Performances of various sectors tend to revert to their historical means over the long term. You need to make sure your portfolio is properly positioned as sector performance changes from year to year.
IMO
None of this is rocket science. It is all common sense. The mathematics is easy – just multiply your account balance by your allocation percentage, and, voila! you have your allocation to your sector. The biggest problem is remembering to do it, and having the discipline to reallocate your portfolio. Consult with a skilled financial manager to determine the appropriate investment allocation for you, given your situation (shameless self-plug here!). This conversation could involve a discussion with your advisor about the state of the various investment markets as well as a monitoring of your current life objectives. Give yourself peace of mind. Portfolio in balance = Life in balance.