COLUMN-The portfolio rebalancing act: Feels bad, works good

Tue Jan 21, 2014 3:30pm EST

By John Wasik

CHICAGO Jan 21 (Reuters) - For most investors, portfolio rebalancing is an unnatural investment act. You sell off winners to buy laggards - an unsatisfying move.

Over the long haul, though, rebalancing makes sense because it lowers market risk and keeps you right with your investment goals: You'll reap a higher annualized return if you do it on a regular basis.

I rebalance once a year, although I'd rather do my taxes, which is marginally less unpleasant. This year my wife and I have a particular need to rebalance since our main retirement portfolio mix has drifted to nearly 60 percent stocks and 40 percent bonds away from our 50/50 allocation goal.

Our mutual fund company provides a nice pie chart on our statement, so the mix is easy to track. Check your annual 401(k) statement to find this information, or do the math.

Normally having a 60/40 stock-bond mix isn't such a bad thing, except that we decided to pare equity exposure in 2009 after the rout the year before.

Here's the difficult part: Although stocks had a great year in 2013 - up 30 percent - we'll have to sell some of our stock holdings for bonds. I know from research this is the prudent thing to do (see below). We consulted with a certified financial planner to plot this transaction, but you can easily do what we did on your own.

First, we sold a portion of a large-company stock fund to buy shares in an international bond index fund. Since we didn't have any global bonds in our main retirement portfolio, this was a good move for diversification. Then we sold shares in an inflation-protected securities fund to invest in a short-term bond fund, again to diversify.

You're probably wondering why we sold a bond fund holding inflation-indexed securities and bought another income fund. I wondered too. My initial rebalancing idea was to move into more inflation-protected bonds, or TIPS, since unlike most bonds, TIPS increase in value when the cost of living climbs.

The planner pointed out that TIPS are more volatile than plain-vanilla bond index funds.

The fund we held - the Vanguard Inflation-Protected Securities Fund - lost nearly 9 percent last year, compared to an index of the broad U.S. bond market, which receded only about 2 percent. The Vanguard fund charges a mere 0.2 percent in annual expenses, but has a negative yield and an above-average amount of risk for a bond fund, according to Morningstar.

The short-term bond fund the planner suggested not only made money last year, it had much less risk than the inflation-protected fund. It was the Vanguard Short-Term Bond Index, which gained less than one percent in 2013 and charges 0.10 percent in annual expenses for so-called admiral shares, which are cheapest and based on assets under management.

Why does the short-term bond fund make sense in terms of lower risk? It holds shorter maturity securities, which are less sensitive to interest rate increases. If you're concerned about rates rising this year - many pundits suggest they will climb - then shortening maturities in your bond holdings is a solid move.

REBALANCING: ONCE MORE WITH FEELING

There's a wealth of academic research that shows the benefits of rebalancing annually.

One respected 2002 study by Lisa Plaxco and Robert Arnott demonstrates significant return advantages for rebalanced portfolios over those allowed to drift.

For portfolios invested primarily in U.S. stocks, there was about a 2 percentage-point advantage to rebalancing compared to a "drifting" mix and a 1 percentage-point gain for global stocks, the researchers found. For the U.S. holdings, they studied securities prices from 1968 to 2000; for global investments, the span went from 1980 to 2000.

Rebalancing also offers a bonus in the form of lower overall risk, Plaxco and Arnott found. When you don't rebalance, your portfolio becomes more concentrated in securities that tend to be overpriced. That means a higher downside risk when the market corrects or collapses. Witness 2008.

Of course rebalancing won't work if you don't have a target mix that's right for your age, the stability of your profession and your tolerance for risk.

My wife and I like a 50/50 allocation because we're both in our sixth decade and still saving for our daughters' college education. Those in their 20s or 30s might feel comfortable with a 60/40 stock-bond portfolio. Retired investors might find a 30/70 allocation suitable.

The core principle for all this planning is to have a basic investment policy statement that guides your investment goals and portfolio mix. Like your rebalancing move, you should review it only once a year and forget about it the rest of the time.

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