Rebalancing pros and cons

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Portfolio rebalancing describes the process whereby investors rejigger their investments to get them to conform to their target asset allocations.

A simple asset allocation classifies investments as either stocks, bonds or cash, where cash is shorthand for money-market investments. Investors can add additional asset categories to include alternative investments, foreign stocks, foreign bonds, emerging-market investments, real estate, etc. The degree of specificity depends on the investor’s need for specificity in these asset classes.

Rebalancing forces the investor to prune back the asset classes that have done particularly well since the last time the portfolio was rebalanced. For example, the U.S. equity market has done particularly well this year. If the investor’s targeted asset allocation is 60 percent stocks, 30 percent bonds and 10 percent cash, and the portfolio is currently 75 percent stocks, the stock position gets pared back and the proceeds get allocated to bonds or cash to bring the portfolio back to its targeted asset allocation.

Rebalancing is not without controversy. I’ve talked in early blog posts about letting your winners run. Why get out of winning positions to buy asset classes that aren’t performing well? Selling some of your outperforming asset classes guarantees you’ve taken some profits while remaining invested in the asset class.

What’s hard this year in rebalancing a portfolio is that the other asset classes just look so darned unattractive. The expectation is that bond yields are headed higher while cash investments are expected to stay low because of the Federal Reserve’s policy.

Higher bond yields mean lower bond prices, so bond investing could result in bleak returns next year. Although to be fair, the market has been worried about higher yields for several years now, and investors that sat out of bonds missed past years’ rallies. In 2013, we did see the 10-year Treasury note go back up in yield from a low of 1.66 percent to around 2.75 percent as we approach the end of the year. Adding to your cash position is only going to make you feel good if interest rates head higher or the stock market heads south.

There can be important tax considerations in rebalancing when investors do it in taxable accounts. The tax impact isn’t as relevant in tax advantage accounts like retirement accounts.

One way to finesse the tax issue is to rebalance over the coming year by how next year’s contributions to retirement and taxable accounts are invested.

Don’t forget that it’s all your money. Look at your overall asset allocations, not just the allocations in your retirement accounts.

What’s your approach to rebalancing your portfolio? Is it triggered by the calendar or by how your asset allocations have changed?