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Submitted by: Frank Armstrong
Frank Armstrong, is President and founder of Investor Solutions, Inc. He is a pioneer in integrating academically driven portfolio management techniques with institutional best practices for individual investors around the world. Frank has over 30 years experience in the securities and financial services industry. He holds a B.A. in Economics from the University of Virginia and is a CERTIFIED FINANCIAL PLANNERŪ practitioner.
Once you have set up the "perfect" asset allocation plan, you can kick back and relax for a while. But, eventually, you will have to do a little maintenance. Over time, your various asset classes will grow at different rates. So, your "perfect" plan will get a little warped.
As in everything else about investing, there are guidelines, suggestions, and considerations, but no hard rules. Every investor will have to examine his own situation and come to his own conclusions. We are assuming here that there is no life event that would force us to re-examine whether the asset allocation plan was still suitable.
We re-balance to keep the original asset allocation plan in order to hold risk constant. For instance, suppose that our original plan called for 30% short term bonds, and 70% equities. If we do nothing, we presume that the equities will outgrow the bonds over the long haul. As the percentage of stocks rise, the character of the portfolio changes. While a higher loading in equities may be good for long-term performance, it will place the portfolio at increasingly higher risk.
A side benefit of re-balancing is that it forces us to buy low, and sell high. Over time we should expect a small, but measurable profit as a result of this "diversification benefit". This works particularly well in well-diversified multi-asset class portfolios like what we recommend.
You should look at both taxes and transaction costs before you decide on your rebalancing strategy. Hyperactive trading is unlikely to add value. Benefits of an absolutely "perfect" asset allocation could easily be consumed by additional costs.
Here's a strategy you could use for starters: Once a year check to see if any asset class varies from its target weight by more than 3%. If so, consider re-balancing inside any qualified plans first to save taxes. In smaller accounts, or if the total amount of the transaction is small, you might decide to just let it ride. A large number of $50 transactions are unlikely to impact your end result.
A natural and painless time to re-balance is whenever there is a cash flow to the account. Whether you are depositing or withdrawing, check to see which classes are out of line and use the cash flow to move back toward "perfect".
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