Rebalancing, The Forgotten Facet Of The February Four

We are now entering the last week of February, the month known for four things: the Super Bowl, Groundhog's Day, Valentine's Day and rebalancing.  Rebalancing?  What's that?  Rebalancing is the exercise you should all be doing once a year to make sure that the retirement savings you've accumulated are being maintained in the proportions you have earlier decided are the correct ones for you.  If you don't rebalance, it is easy for your savings to become furtively unbalanced, and that would be a bad thing.  To be honest, the important thing is to rebalance annually.  The month in which you choose to do so is not so important, as long as it's the same month each year.  I prefer February, as explained in Section VI below.

I. What it means.  Let's say that after consulting your Uncle Hubert, reading tea leaves, discussions with the boys and girls around the water cooler, throwing darts at a board and perusing the Wall Street Journal, you have decided that the percentages your retirement savings should "be in" are 70% stocks, 20% bonds and 10% cash.  Stocks, bonds and cash are the three main categories of most retirement portfolios.  (Others might include real estate, commodities and alternative investments, but for purposes of this post we are only going to consider the main three.)  The percentages you choose will be based on a number of factors, including your age and your risk tolerance.  If you start out the twelve month period with $10,000 in savings, the 70-20-10 ratio you chose would result in you having approximately $7,000 invested in stocks, $2,000 invested in bonds, and $1,000 in cash.

Now let's say that the stock market has a banner year, and your stock portfolio grows by 15%, while the bond portion dips 10% and cash portion of your savings remains stagnant throughout your selected twelve month period.  You now have $8,050 in stocks, $1,800 in bonds, and $1,000 in cash, for a total of $10,850.  But what has happened to the 70-20-10 allocation you so carefully had decided was right for you?  It now looks like this:  74.2% stocks, 16.6% bonds and 9.2% cash.  There are worse things in the world than having your allocation out of whack by just a few percentage points, such as in the foregoing illustration, but a preferred discipline is to do an annual rebalancing anyway.  The older you get (or put another way, the closer you get to when you'll need your money) and the more money you have saved, the more important rebalancing to your desired allocations becomes.  Your immediate goal (subject to what I've written in Section V below) should be to get back to the allocation you started with for that period.  That's what is known as "rebalancing."

II. Why bother?   There are at least two reasons why taking the time to rebalance annually is worth your while.  First and foremost is risk management.  Do you remember the term "false prophets" being used in the Bible?  There are also false prophets in the investment world.   Don't believe anyone who claims she can "time the market."  That person is the modern day version of a false prophet.  Any time you invest in anything other than cash or federal government securities, you are taking a risk.  But if cash and fed securities were all we invested in, we would never make any real money.  In fact, if you take inflation into account, you'd be losing money (buying power) in some years.  The only way for most folks to make real money with their investments is in the stock market, either by being a picker of individual company stocks, or by investing in one or more mutual funds which concentrate on stocks (sometimes called equity funds).  Of the three main categories identified in Section I, stocks have, by far, the most upside potential, but also carry the most risk.  So, when we set our desired allocation percentages for the year, we are managing how much risk we are willing to take.  The higher the allocation for stocks, the more risk we are taking.  The percentages we set at the beginning of the annual period should not be drastically different from those we had set at the start of the immediately preceding period.  Thus, if we started out Year 1 with a stock allocation of 70% and end up with 74.2%, we should probably scale down our risk to something closer to that 70% for the beginning of Year 2.  (Note: Some gurus' advice is to wait until one of your portfolio's components gets seven to ten percent away from your desired allocation before rebalancing.  I do not agree with that approach because it's too easy to put your savings on automatic pilot and do nothing.  Inertia is a powerful force.)

It has often been said that the best advice one can receive regarding investing in the stock market is to "buy low and sell high."  Ah, yes, if only it were that easy!  But you don't know exactly when a stock which you'd like to buy is going to hit its nadir, nor do you know exactly when a stock you're willing to sell will hit its peak.  Remember, no one knows for sure how to time the market.  That gets us to our second reason why an annual rebalance is a good thing:   It forces you to buy low and sell high.  This concept is often overlooked when financial columnists write about rebalancing, probably because of risk management (the reason discussed in the immediately preceding paragraph) being so important.  If you need to trim, say, 4.2% of your stock holdings to get back to your desired allocation percentage, simply pick the stock(s) that has been the best performing and you will undoubtedly be selling high.  (Now is a good time to relay to you some advice I received from a trusted financial advisor:  Once you sell, don't look back!  In other words, if you sell a stock and the next day its price goes up, don't kick yourself.  No one can time the market! (There, that's the third time I've written that!)  Do a good job deciding which stock to sell, and then once you do, be confident you made a smart choice no matter what transpires down the road.)

The same general idea follows if you need to buy in order to rebalance.  Using our original example, if you need to buy bonds (or mutual funds which concentrate on bonds) to get back up to the desired 20% allocation, there is a good chance the bond market is down.  (Otherwise your bond portfolio may not have shrunk.)  That is the time to buy bonds rather than when bonds are soaring.

III. How to rebalance.  There are two ways rebalancing can be accomplished.  The most common way is what I've already described above.  You can sell the assets in those categories which have an excess allocation, and use the proceeds to acquire assets in the categories which have a deficit allocation.  If cash is a deficit category, then the proceeds from the sale of surplus categories would simply sit as cash.  After consummating these sell and buy transactions, the aggregate amount of money in your overall portfolio will be roughly the same as before your rebalancing transactions.

The second way to rebalance is to use new money to bolster your deficient asset categories by buying assets of that type, without selling assets from your surplus categories.  "New money" can include a redirection of dividends and/or interest generated from assets already in your portfolio.  Obviously, "new money" can also mean money which is not currently connected to your portfolio, such as money from future pay checks, an inheritance or winning the lottery.  Also obvious is that rebalancing with new money results in the aggregate amount of your overall portfolio being greater than before you rebalanced.

Some financial institutions offer automatic rebalancing for their clients.  I don't have a problem with that although I would have two words of caution.  First, don't opt for more than an annual rebalance.  Anything more frequent is sheer falderal, and could make the fees associated with your retirement account(s) higher.  Second, if you do opt for auto-rebalancing, make sure you understand how the rebalancing is accomplished.  You may someday have your money with an institution where the auto-rebalance is not offered, so you need how to DIY if need be.

IV. Choosing the right account.  When you decide the percentages in which your retirement funds shouId be allocated, you must take into consideration the funds in all of your retirement accounts, including pre-tax accounts (e.g., 401(k), 403(b) or traditional IRA), taxable accounts (e.g., a brokerage account) and Roth accounts.  If you have more than one of those types of retirement accounts, when it comes time to rebalance you will be faced with the decision of which of them to choose for said rebalancing.  It almost always makes the most sense to choose the account for which the sale of an asset will not, of itself, trigger an immediate taxable event.  For example, if you sell appreciated stock out of a traditional IRA, and kept the sale proceeds within that account, there would be no immediate tax impact.  You don't pay taxes on traditional IRA funds until they are withdrawn (which, ideally, would be after you retire).  Contrast that with what happens when you sell appreciated stock out of a brokerage account.  That is a taxable event, meaning that you will pay taxes on the gain at the end of the current tax year.  (Gains made from the sale of securities in a taxable account are taxable, either at capital gains or ordinary income rates, depending on how long you've own the security prior to unloading it.)

V. Selected ratios are not static.   One point of clarification with respect to the second-to-last sentence of Section I.  The desired allocation percentages you choose will change over time.  Conventional wisdom dictates that the older you get, the more you should rein in your riskier investments.  Some people might change their percentages every year. For example, a thirty year old might have 80% of her retirement funds in stocks, then ratchet it down to 79% for the year in which she turns age thirty-one.    When you rebalance at the start of a given year ("Year 2"), the percentages you hope to reach via rebalancing should be those you've selected for Year 2, which may be different from those you had selected for Year 1.

VI. A plug for February.  I select February as my rebalancing month mostly because (i) it is near the beginning of the calendar year, and I like to have all my ducks in a row for the year, (ii) January tends to sneak up on people, and having a goal of rebalancing in January might prove to be a little too optimistic or aggressive (similar to keeping New Year's resolutions), (iii) I like to reserve the month of March for working on my taxes, or at least accumulating and organizing my documents, and (iv) February is a relatively boring sports month, so the time it takes to do the rebalancing exercise is not pulling me away from ESPN-watching.

VII. A bad scenario.  In case you're on the fence regarding whether you want to bother yourself with rebalancing, let me try ending this post with a horror story.  Don't be the guy who, for his entire working life, has never rebalanced.  His stock portfolio has reached 85% of his total retirement portfolio.  But at age sixty, the market takes a precipitous fall, and a long-term bear market begins.  His portfolio worth is a shadow of its former self.  Because of his age, he has little time to recoup (aka, a short investment horizon) to build his account back up to being close to what it was before the crash.  Had he rebalanced, and made the types of adjustments described in Section V, he would not be in this pickle.

You only go around once. Play it smart, and rebalance annually.