Few investors can forget the damage wreaked when the high
technology bubble burst in 2000, chopping 46% from the
technology-dominated NASDAQ Composite Index by the end of
2002.1 But how many have learned from the tech wreck and
ensuing bear market and acted to protect their portfolio against
unexpected risk? Those who have learned make sure they periodically
review the balance of assets in their portfolio.
For each review, they calculate how much of their money is in
stocks, bonds, and other asset classes. Then they decide whether
they are comfortable with those allocations. If not, they rebalance
to bring the allocations back to their intended targets.
Rebalancing can be accomplished in one of two basic ways: selling
investments in the asset class that exceeds the target and buying
investments in the underweighted asset or using new money to
increase the underweighted asset.
However, many investors dislike rebalancing because it means
selling winners in favor of losers. Rebalancing can also generate
transaction fees, as well as taxes on gains created by selling
securities. Nonetheless, most financial professionals believe the
advantages outweigh the disadvantages.
Correcting for Allocation Drift
To appreciate how performance differences can affect an
unbalanced portfolio over time, throwing it more and more out of
sync with its original allocations, consider what happened to a
hypothetical portfolio left unbalanced for the 20 years ended
December 31, 2020 (see chart). As you can see, the original 70%
allocation to U.S. stocks grew to 82%, while the other allocations
shrank, reducing their intended risk reduction role in the
portfolio. As always, past performance is no guarantee of future
results, and asset allocation and diversification are no assurance
Bonds haven't been as volatile as stocks over long periods, but
recent history shows that they, too, can experience performance
patterns that may alter asset allocation over time. Consider the
divergence of the stock and bond markets in 2008 and how that
affected asset allocations. While the S&P 500 lost 37% during
this period, long-term U.S. government bonds gained 23%. A
portfolio composed of 50% of each at the start of the year would
have shifted to an allocation of 34% stocks and 66% bonds at year's
|Drift Can Expose a Portfolio to Greater
|Source: ChartSource®, DST Retirement Solutions,
LLC, an SS&C company. Domestic stocks are represented by the
total returns of the S&P 500 500 index, an unmanaged index that
is generally considered representative of the U.S. stock market.
Bonds are represented by the total returns of the Bloomberg
Barclays U.S. Aggregate Bond index. Money markets are represented
by the Bloomberg Barclays U.S. Treasury Bill 1-3 Month index.
Foreign equity is represented by the total returns of the MSCI EAFE
index. It is not possible to invest directly in an index. Index
performance does not reflect the effects of investing costs and
taxes. Actual results would vary from benchmarks and would likely
have been lower. Past performance is not a guarantee of future
results. © 2021 SS&C. All rights reserved. Not responsible
for any errors or omissions. (CS000128)
Seeing the Whole Picture
If you have multiple investment accounts, determining whether to
rebalance may involve several steps, beginning with a check of your
overall allocation. This entails figuring how your money is divided
among asset classes in each account and then across all accounts,
whether in taxable brokerage, mutual fund, or tax-deferred
To gain a full appreciation of your investment strategy, go
beyond stocks and bonds and calculate the percentages you have in
other asset classes, such as cash and real estate. In addition, you
may want to evaluate your allocations to categories within an asset
class. In equities, for example, you might consider the percentages
in foreign and domestic stocks. For the fixed-income portion of
your portfolio, you might break your allocation into U.S.
Treasuries, municipals, and corporate bonds. If you're pursuing
income from bonds, you may want to know the split among short,
medium, and long maturities.
How often should you rebalance? The usual answer is anytime your
goals change; otherwise, at least once a year. However, to keep
close tabs on your investment plan and make sure it doesn't drift
far from your objectives, you may prefer to set a percentage limit
of variance, say 5% on either side of your intended target, that
would trigger a review and possible rebalancing.
|Consider these possibilities for reducing transaction costs and
taxable gains when rebalancing:
- Make as many changes as possible in an account that charges low
trading fees -- for example, a 401(k) account, which may offer free
transactions, or a low-cost brokerage account.
- To avoid tax liability, rebalance using new money instead of
moving existing money around. Or limit your immediate tax liability
by making changes when possible in a tax-deferred account like a
401(k) or an individual retirement account (IRA).
- If you're looking for new money to help rebalance your
portfolio, consider using lump-sum payments such as a bonus or tax