Personal Finance 101: What Is Rebalancing?

Step by Step Guide to Portfolio Rebalancing

pf101One topic I see referenced quite often in personal finance books – especially books focused on retirement – is the idea of rebalancing. It’s often discussed as though the writer assumes that the reader knows what rebalancing is, but given the confusion I sometimes see in reader emails, I don’t think the idea of rebalancing is often clear to people.

So, let’s walk step by step through the story of rebalancing. I’m going to look at this with regards to retirement savings, but it’s true for any kind of investments.

It All Starts With Risk

When a person puts money into their retirement account, they’re faced with a lot of options for how to invest that money. Some of the investments are risky, but offer the potential of a lot of returns – stock market investments are a good example of this. Other investments offer somewhat less risk, but lower returns – bond investments are often a good example of this. There are also very low risk investments with low returns, like a money market account.

While you’re facing all of those choices, there are a couple “rules” of investing that are also in play that you should be thinking about.

The further you are from retirement, the more risk you can stomach. Generally, investments with high risk feature a high return, but that high return comes only over the long haul. You’ll see years with a 20% drop and other years with a 30% gain, for example, and over a lot of years, you’ll have a nice average. Since you’re not going to be pulling your money out in the next few years, you can easily stomach those 20% drop years in order to gobble up those 30% gain years. Over the course of a lot of years, you’ll be in good shape.

Of course, on the flip side of that, you’ll want less risk when you get closer to retirement. If you’re just a few years from retirement, a year in which you lose 20% of your retirement savings isn’t something you want to be facing. The market might rebound next year… but it might not, too. You’re going to want your money someplace safer.

Also, diversity is a good thing. You never want all of your eggs in one basket.

So, what does that mean for you? You’re probably not going to want to put all of your money in just one investment. At the same time, you’re also going to want to slowly get safer and safer with your investments as you get closer to retirement.

Rebalancing is how you do that.

The Plan

If you read pretty much any book on retirement – or any book on investing, for that matter – you’re going to eventually stumble upon the idea of asset allocation.

An asset allocation is simply an investment plan for a specific situation, nothing more, nothing less. It’s a list of investment types (or even specific investments), along with recommendations of how much of your money should be in each investment type.

So, for example, you might read in a retirement book that a person 30 years from retirement should have an asset allocation like this:

50% domestic stocks (meaning stocks from U.S. companies)
30% international stocks (meaning stocks from international companies)
10% real estate
5% bonds
5% cash

We’ll look at this asset allocation for starters.

Books will give lots of reasons for their specific asset allocations and retirement plans. I won’t get into the “ins” and “outs” of these, aside from saying that I trust the advice given in The Bogleheads’ Guide to Retirement Planning.

When you sign up for retirement, in order to follow this asset allocation, you’d just copy those percentages onto the forms you fill out. You’d find a “domestic stocks” investment, probably an index fund, and mark it down as receiving 50% of your savings. You’d find an “international stocks” investment, probably another index fund, and mark it as receiving 30% of your savings. You get the idea.

So, you’re off to the races. You save that money each paycheck for a year. At the end of that year, you check out your retirement savings. It looks like this:

$600 (or 60%) in your domestic stocks investment
$225 (or 22.5%) in your international stocks investment
$75 (or 7.5%) in your real estate investment
$50 (or 5%) in bonds
$50 (or 5%) in cash

So, what happened? During the year that passed, the domestic stocks did really well, but the international stocks did really poorly. The real estate did fairly poorly, but not overly so, and the bonds and the cash stayed pretty steady.

Just because stocks in the US go up does not mean that international stocks will go up, real estate will go up, or anything else will go up. Some will go up. Some will go down. Over the long term, they’ll all ideally go up, but year to year, some will go up and some will go down.

The problem is that your investments now look different than your original plan.

Your domestic stocks went from 50% to 60% of your investments.
Your international stocks went from 30% to 22.5% of your investments.
Your real estate went from 10% to 7.5% of your investments.
The other parts stayed the same.

This situation is now somewhat more risky than it was before. You’re now at 82.5% of your money in stocks, whereas your plan is only at 80%. Even more, your domestic stock market percentage went from 50% to 60%. You’re now more at the mercy of the domestic stock market than you were before.

That’s bad. The point of having a plan was to keep your risk spread out among a bunch of different investments. You’ll want to fix that.

This is the moment when you rebalance.

The Rebalance

So, you have

$600 (or 60%) in your domestic stocks investment
$225 (or 22.5%) in your international stocks investment
$75 (or 7.5%) in your real estate investment
$50 (or 5%) in bonds
$50 (or 5%) in cash

You want

50% domestic stocks
30% international stocks
10% real estate
5% bonds
5% cash

You need to take money from your investments that are higher than the percentage you desire and move them to investments that are lower than the percentage you desire.

So, the first step you do is you add up the total amount that you have in your investments. You currently have $1,000.

Then, you figure out what you should have in each of your investments.

For domestic stocks, you should have 50% of $1,000, or $500
For international stocks, you should have 30% of $1,000, or $300
For real estate, you should have 10% of $1,000, or $100
For bonds, you should have 5% of $1,000, or $50
For cash, you should have 5% of $1,000, or $50

Next, you take money out of investments that are too high. You have $600 in your domestic stocks, so you’d want to pull $100 out of it, bringing it down to your $500 target.

At the same time, you’ll want to move that money into other investments that are too low. You only have $225 in international stocks and want $300, so you’ll put $75 into international stocks. You also only have $75 in bonds and want $100, so you’ll put $25 into bonds.

So, in the end, you just take $100 out of the domestic stocks, put $75 of that into international stocks, and put the remaining $25 into real estate. After that, everything matches your plan.

That’s all rebalancing is. You’re just moving money from some of your investments to your other investments so that the balances once again match your plans.

The Easy Path

Once you understand it, the actual process of rebalancing is straightforward, but there is a lot to keep track of. Not only do you have to figure out your desired asset allocation, you have to also make sure that your money matches it on a regular basis (many people do it yearly), but you also have to update your planned asset allocation regularly so that you slowly have less risk over time.

For a lot of people who are saving for retirement, this is all overwhelming. You might not want to deal with your own asset allocations or figuring out the changes. Can’t this all be simpler?

That’s where target retirement funds come in. Target retirement funds are investments you can choose where they do all of this rebalancing work for you. Not only do they constantly rebalance things so that you’re always matching their asset allocation plan, but they change the plan over time as you get closer to retirement. They slowly lower the amount of risky investments and slowly raise the safer investments so that a stock market shock close to your retirement date won’t devastate your plans.

(Of course, there’s a cost. Many target retirement funds charge a small fee for doing this, usually a tiny percentage of the money you have invested.)

For people who have no interest in digging into the nuts and bolts of actively rebalancing their retirement savings, a Target Retirement fund is a good choice. You simply contribute 100% of your retirement to whichever fund is closest to your retirement date (for example, if you’re going to retire in 2039, you’ll want to invest in Target Retirement 2040) and just let it sit. You won’t get quite the same results as if you balanced things yourself, but it’s far easier.

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