When you set up your 401(k), 403(b) or 457 plan, you either selected funds based on your own asset allocation goals or picked a life cycle or target-date fund that allocated your investment dollars using risk tolerance or your projected retirement age as a guide. Your portfolio was carved out among large U.S. company stocks, small U.S. company stocks, foreign stocks, fixed-income investments and so forth.
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But over time, assets grow at varying rates. As one category leaps beyond your targeted percentage and another shrinks to a lower level than you desire, it’s time to consider rebalancing your portfolio.
An up or down swing in the stock market is not one of those times, says Stuart Ritter, vice president and Certified Financial Planner with T. Rowe Price Investment Services in Baltimore. Ritter maintains your asset allocation should always reflect your goal’s time horizon, or how much time you have before you want to retire.
“Let’s say I’m in my early 50s,” he says. “I should have about 80 percent in diversified equities and 20 percent in diversified fixed-income. That’s my target. And that target is based on my goal’s time horizon. It’s not based on what the stock market did in the last three weeks. It’s not based on what people are prognosticating is going to happen in the next three quarters.”
Checking your portfolio for balance
Colleen Jaconetti, an investment analyst with the Vanguard Investment Strategy Group in Valley Forge, Pa., says investors should review their portfolios once or twice per year. “Maybe select an anniversary — the first of the year, tax day, their birthday — and rebalance when the portfolio deviates from their target by more than 5 percentage points,” she says.
On the other hand, Steve Raymond, a financial planner at Navion Financial Advisors in Gold River, Calif., recommends checking on the status of your asset allocation at least monthly, paying attention to how closely it matches your target rates. Ritter falls in between, advocating a quarterly review.
Rebalancing when the allocation is off
Although he advises frequent portfolio checkups, Raymond says you will typically need to rebalance only once or twice per year.
For Jaconetti, how often to rebalance depends a lot on how much of a deviation you are comfortable with and how much it will cost you to tweak your portfolio to get it back in line with your original target.
“If it’s a tax-deferred plan, such as a 401(k), they would not have to pay any taxes” as a result of making changes, Jaconetti says. “The only fees an investor would have to think about would be transaction costs for processing the trade.”
Possible transaction costs include sales charges, exchange fees and back-end loads. Additional costs might include fees paid to an adviser for help with evaluating your next move and carrying out the transaction.
“Research indicates that if any one of (your) asset allocations is 20 percent out of whack, you need to rebalance,” says Raymond, citing a paper in the January 2008 issue of the Journal of Financial Planning by Gobind Daryanani. “Let’s say you want to have 30 percent of your portfolio in large U.S. stocks. As long as your portfolio has between 24 percent and 36 percent in those large-cap stocks, you’re OK.”
Revising your asset allocation plan
Suppose you’re concerned that your original asset allocation may no longer be working to your advantage. Should you scrap it and set new investment targets? According to Raymond, a change in your risk tolerance — not the desire to get higher returns — should be the determining factor.
“The investor may decide that the market is too volatile for comfort or that the original allocation is too conservative,” Raymond says. “A major life change or financial event may also call for an adjustment to your asset allocation model.”
That event could be an income boost from a large inheritance or a work bonus. “You don’t need to be as aggressive in your investing,” Raymond says. “You can be a little bit more conservative and take a smoother road to your destination.”
On the other hand, if your health is declining and you need to retire sooner than originally planned, you may need a more aggressive portfolio to make that possible, in Raymond’s view.
Tinkering too much or not enough
Raymond warns that constantly changing your asset allocation in response to market whims can put you on the wrong track.
Let’s say you decide to change from an 80/20 stocks-to-bonds ratio to 60/40, selling off stocks because the stock market is down. Later, you hear news of a market turnaround and decide to put all your retirement savings back in stocks. What you’ve done is sell low and buy high — the exact opposite of what investment planners advise.
On the other hand, by selling your outsized positions on an annual basis and increasing your stake in the funds that performed poorly due to the cyclical nature of their holdings, you will have succeeded in buying low and selling high. It’s a counterintuitive move that’s tough to do in practice.
As Jaconetti points out, there is a downside to doing nothing at all. By letting your winners ride, “you would be taking on more risk,” she says.