An Easy (Re)balancing Act

I last waxed on about mindful consumption -- having a spending plan so that you can make better decisions about how you want to balance saving with enjoying "the good life". To continue the mindful personal finance theme, today's post covers rebalancing your portfolio. The best part is, it's easy to do and you only need act once a year! Put it on your calendar next to "deal with taxes". And open something zippy and fresh like a Gewurztraminer to quell the dull ache produced by the topic :)

Rebalancing is when you reallocate or realign the funds in your portfolio to your original intended percentages. Why do this? Over the course of the year, as some investments grow and others decrease, your allocations become skewed. Let's look at a simple hypothetical two-fund portfolio without contributions during a one year period to examine the concept:

January '07
Fund A - $1000
% Allocated to A - 50%
Fund B - $1000
% Allocated to B - 50%
Total Value = $2000

Dec. '07
Fund A - $1,100
% Allocated to A - 52.6%
Fund B - $990
% Allocated to B - 47.4%
Total value = $2,090

The HMW's desired allocation is 50% in each fund. In January, her $2000 is split evenly between Funds A and B. Over the course of the year, Fund A gained 10% and Fund B lost 1% (this HMW earned 9% on her investment). Due to these gains and losses, the percent allocated to each fund has changed. Fund A now represents 52.6% of her portfolio and Fund B, 47.4%. While the percentage change in each is not drastic in a year, over time, failing to rebalance these allocations could skew this HMW's goals.

You might be wondering why she should reallocate and buy more Fund B when the investment is down? It sure seems tempting to "ride" a higher performing fund (or stay overweight in Fund A), which is why reallocating can be psychologically difficult. However, it's important to do so because very few investments or funds move in the same direction every year. And it's very difficult to predict future returns. What you can expect and grasp is that change is normal! Fund A might hold international investments that do very well for several years, but then lose some of their gains. Fund B might make a come back during Fund A's down years. No one can predict what's going to happen.

That's exactly why the most important thing to do (other than contribute and save) is to create an allocation based on sound investment principles and stick to it. Don't try to chase returns -- doing so is about as fruitful as chasing men. It rarely works, and when it does, it's susceptible to future failure.

Most online investment accounts have a very simple "rebalance" function or button. If you're not sure how to rebalance your accounts this January, call your provider and find out -- it will keep you on the right track for the long haul. And make sure to add an annual reminder to do so.