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The Art of Rebalancing

If you have money invested anywhere (employer retirement accounts, outside retirement accounts, accounts here at CGN), it won’t be long before you run across the term “rebalance.”

Before putting money into an account, you may have sat down with either a representative for the company plan or an advisor to determine what allocation, or how aggressive, your investment portfolio should be in light of a number of factors (age, risk-tolerance, income level, goals).  Based on this your investment guy selected a set of investment holdings or perhaps just a target date fund that was a certain percentage Stocks and a certain percentage Bonds.

If you picked a target date fund, something like ‘Target Retire 2045,’ then rebalancing happens automatically, since someone else is managing the fund and reallocating everything in increments as you get closer and closer to retirement.

If you picked five stock funds and two bond funds (for example) to achieve an allocation of 70% Stocks and 30% Bonds overall, then you may need to periodically check the account to make sure your allocation is still 70/30 as time goes on.  If the balances in each fund need re-adjusting, this is the act of rebalancing.

Over time, stocks are going to have higher returns and thus a higher value as they naturally grow more than bonds do.  If the stock portion of your portfolio is growing faster than the bond (which should almost always be the case), then you’ll eventually end up with more than the 70/30 allocation you were looking for.

For example, if you put $35,000 of your existing $50,000 401(k) balance into five different stock funds and the remaining $15,000 into bond funds, you’d have a overall allocation of, you guessed it, 70/30.  Let’s assume you stop deferring salary into the account and just watch it grow.  Over time, the stocks are averaging 10% growth and the bonds earning more like 3%.  After two years, the account now has $42,350 invested in stocks and $15,913.50, which is an overall allocation of closer to 75% Stocks and 25% Bonds.  

Left unchecked, your account will continue to drift towards a more aggressive portfolio than you want or need.   The returns will also continue to get better since you have more and more proportionally invested in stocks, but your risk will grow right along with it.

Rebalancing seeks to manage the risk in a portfolio, NOT the return.  Why invest in 90% Stocks and 10% Bonds to earn an average of 12% when you only truly need to invest in a 70/30 earning an average of 7% to achieve your goals?