2 Methods for Rebalancing Your Index Investments

Part of the Index Investing For Dummies Cheat Sheet

Failing to rebalance your index investment portfolio could mean that you're taking on added risk as your diversification dissolves and you become too heavily weighted in one or several types of investment. Your large cap stocks, for example, may outperform your small cap stocks. Your foreign stocks may do better than your domestic stocks. Or your bonds may rise, and your stocks may fall.

Rebalancing also forces you, despite whatever your emotions are telling you, to sell off the recent overachievers and buy up the underachievers. Over the years, you'll find yourself buying low and selling high. That process of buying low and selling high, sometimes known as the rebalancing bonus, may add as much as a full percentage point to your long-term annual average returns.

There are two ways to rebalance your portfolio. Both methods have their fans, and neither is necessarily better than the other. Each approach is fairly easy to do, especially when your portfolio consists of wisely chosen index funds that represent crisp and clear asset classes:

  • The calendar method: This more common method is to attack your portfolio allocations according to the calendar. Most financial advisors suggest rebalancing every year or every 18 months, with the latter being fine for most folks. If you're living off your portfolio and need to raise regular cash, you may consider doing it every six months.

    The advantage to using the calendar is that it gives you a certain discipline and tends to result in less trading (with fewer trading costs and taxes) than using the as-needed basis. The calendar method also ensures that you don't rebalance too often, which allows you to take advantage of the momentum that sometimes drives investments north over a period of months.

    If you use the calendar method, consider buying or selling any piece of your portfolio (such as, for example, a large cap growth index fund) that has shrunk or grown more than 10 percent away from its target position. In other words, if your portfolio plan allocates 20 percent to large cap growth, consider buying or selling should your position be greater than 22 percent or fall short of 18 percent.

    But someone with a smaller portfolio, or someone with an ETF rather than a mutual fund portfolio, may want to use 15 percent instead of 10 percent. The smaller your portfolio, the smaller the positions, and the greater your trading costs may be. You don't want to spend $10 to trade $100 worth of a single index ETF.

  • The as-needed method: Here, you eyeball your portfolio more regularly and rebalance if and when things get out of whack — regardless of whether that's a year from the last time you rebalanced or a week and a half. You do your juggling just as soon as you note a large enough swing to warrant a buy or sell.

    This approach allows for a potentially larger rebalancing bonus but risks eating up that bonus with trading costs and added taxation. Plus, you may lose out on the momentum that drives some securities higher than they sometimes should probably go.

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