

Balancing portfolio requires discipline, counterintuitive thinking

Risk management and a safe glide to retirement sometimes require fighting your instincts. Yes, I said fighting them. That's what it takes to keep your portfolio diversified. Now that tax season is behind us, it's a good time to look at what you have in the bank and come up with a good rebalancing strategy.

What is portfolio rebalancing?

Perhaps the best way to explain it is with a simple hypothetical. Let's say you chose an 80/20 allocation of stocks and bonds in a retirement portfolio worth $200. You buy $80 worth of Google stock and $80 worth of Walmart stock, plus $40 worth of bonds.

A year later, the Google shares have doubled in value to $160. The Walmart stock has tanked to $40. And the bonds' prices have barely moved at all -- they're stable, by design.

Now you have two problems. The first is that your overall allocation is messed up. You now have $200 worth of stocks and only $40 in bonds -- that's an 83/17 split. The second is a little problem called reversion to the mean. Obviously, since Google is doing well, you would like to buy more of it. That would be exactly the wrong thing to do, though. The law of averages tells us that over the long term, Walmart is going to recover and Google is going to fall. This is what I mean by going against your instincts. The investment experts tell us that what you should do now to hedge against risk is rebalance the portfolio. That means buying more Walmart stock and more bonds, until you've recovered your original asset allocation and the desired diverse portfolio.

There's a reason I say that you should rebalance your portfolio by buying, rather than by selling. That's because if you sell a stock that's just gone up, you are going to realize capital gains and have to pay taxes on them. Some possible sources of fresh money to top up your allocations are a bonus, gift or raise; or you could direct your funds' income or capital-gain distributions into a money-market account instead of to current positions, and then use that cash to buy.

Of course it isn't always possible to rebalance without selling anything, but it's worth trying.

The next question to ask is how often to rebalance. Vanguard, the world's largest mutual fund company, put out a paper in 2010 that ran simulations on various portfolios and concluded, "Risk-adjusted returns are not meaningfully different whether a portfolio is rebalanced monthly, quarterly or annually; however, the number of rebalancing events and resulting costs (taxes, time and labor) increase signi cantly." Translation: you are safe, and will probably save money, if you rebalance just once a year.

Another important time to consider rebalancing is when changing jobs. If you are rolling over a 401(k), either into a new 401(k) or an IRA, you have a chance to pick new positions and new funds.

Vanguard also recommends a 5 percent threshold, which means you don't rebalance until your portfolio mix has moved more than five percentage points away from the target. That means, in the example above, you actually wouldn't have to buy more bonds yet because you're within three percentage points of your desired stock/bond mix. However, you would still have to buy more Walmart stock, because you went from 50/50 Google/Walmart to 80/20.

Rebalancing is key to risk management in any investment strategy, but it requires that you be confident of your portfolio mix to begin with. In the real world, optimal diversification gets much more complicated than just buying two stocks. We'll talk more about diversification in a future column.

The final point to keep in mind is that you don't always rebalance to keep the status quo. The best balance between equities and safer investments will change based on when you expect to retire and your risk preference. The 80/20 stocks/bonds mix looks good in my 30s, but by my 50s it'll be more like 60/40.

(Anya Kamenetz' latest book is "DIY U: Edupunks, Edupreneurs, and the Coming Transformation of Higher Education." She welcomes your questions at


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