Understanding Rebalancing: A step-by-step overview



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If you've put off rebalancing because the process seems daunting to you, read on. The following step-by-step guide may help simplify the process:


Step 1: Determine your asset-allocation targets.

Your first step in the rebalancing process is to make sure you have an asset-allocation framework. If you had a stock/bond target that made sense for you before the recent market downturn, it should still fit now. And if you don't have an asset-allocation plan, it's time to make sure you have one. My favorite "quick and dirty" method of getting in the right asset-allocation ballpark is to look at the asset allocations of target-date mutual funds geared toward individuals in your age range. Of course, there are no one-size-fits-all asset-allocation solutions—none of us knows how long we'll live, for one thing. These funds also vary widely in their asset allocations and in their overall quality


Step 2: Find your current asset allocation.

After you've determined what your optimal asset allocation should be, it's time to take a look at where you are now. If you're like many people, you may have been moving your investment statements directly from the mailbox to your desk drawer, afraid to glimpse how much money you've lost. But it's time to pull all of those statements out and take a look, or go online for an even more current view of your portfolio.


Keeping track of your portfolio's asset allocation by hand can be a bit cumbersome and inexact, particularly because most mutual funds aren't pure stock or bond. It's not uncommon for stock funds to hold double-digit cash stakes, for example.


Step 3: Identify candidates for tax-loss selling.

Before you begin altering your portfolio to put your asset allocation back in line with your targets, you also want to scout around for tax-loss candidates that you hold in your taxable accounts. If you're like most people, you won't have to look too hard to identify securities that are now priced more cheaply than what you paid for them.


Step 4: Formulate a rebalancing plan.

If your portfolio is in line with your target asset allocation and you're not making any inadvertent style or sector bets, you may think your work is done.

Most likely, however, your analysis of your current asset allocation versus your targets indicates that your portfolio is light on stocks. At the same time, the securities that you've identified for tax-loss selling are also likely to be stocks and stock funds.

When it comes to deciding which securities to add, as well as how much to add to each, you'll probably find that the process of rebalancing your portfolio is a matter of trial and error. Pay attention to the impact that various holdings have on your style-box positioning and sector weightings. Your stock portfolio doesn't need to be an exact clone of the broad market, but you should at least be aware of whether your portfolio is skewing heavily to one style or sector.

In some cases, the alterations you need to make are obvious—if you're heavy on bonds, for example, adding to stocks should help bring more balance to your portfolio. Getting to the bottom of other bets might take a little more research. For example, if your portfolio has more cash than you want it to, that could be because one of your stock-fund managers is holding a lot of cash. You could decide to live with it, and reduce your designated cash holdings accordingly, or else pare back your holdings in the cash-heavy stock fund.

It also pays to consider tax consequences when rebalancing. Conventional wisdom holds that you should concentrate your rebalancing efforts in your tax-sheltered accounts, because you won't have to pay capital gains tax if you determine you need to sell shares. Alternatively, you could try to correct your portfolio's imbalances not by selling but by directing a bigger share of future contributions to those holdings that need beefing up. In so doing, you'll potentially save on tax and transaction costs.


Step 5: Plan to make a habit of it.

There are two ends of the spectrum for rebalancing—either you can rebalance on a set schedule, say, every December, or you can rebalance whenever your portfolio gets dramatically out of whack with your targets. Consider splitting the difference.  Think about scheduling a top-to-bottom portfolio review at a fixed time each year to help keep your asset allocation on track with investment goals, time horizon, and risk tolerance.


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