By John Wasik
CHICAGO Jan 21 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
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
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
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.