I’m a big fan of the “buy and hold” investment strategy, which essentially means that you choose your investments for the long-term and stick with them through the ups and downs. There is no trading or moving in and out of the market based on the events of the day.
But even a buy and hold strategy takes a little bit of maintenance. Part of that maintenance is the need to rebalance your investments every now and again.
Today I’d like to talk about the idea behind rebalancing, why it’s important for investing, and how you can do it simply.
What’s the idea behind rebalancing?
The need to rebalance our investments is very similar to the rebalancing need we often face in our personal lives. As an example, most of us probably have an ideal work-life balance that we like to maintain, with so many hours spent on each. But there are times where that gets thrown out of whack.
You may have a big project at work that requires you to put in some extra hours. You may even have to work over a weekend.
On the other side there will be events in your life that take you away from work more than usual. Vacations are a perfect example. Having a baby is another one.
Both of these things will not only throw you out of balance for a period of time, but they should be expected. It’s reasonable to think you’ll have to work more than usual at times, just as it’s reasonable to take time away from work at others.
But in each case you will eventually have to recognize the imbalance and take steps to fix it. Your work project will end and you can get back to being home for dinner. You will return home from vacation and have to get back to your job. You bring your life back into balance.
Your investments get out of balance too
If you’ve chosen an asset allocation that includes different types of investments, such as stocks and bonds, they will occasionally stray from whatever target percentage you pick. This will happen simply because the market returns will cause one or the other to grow or shrink in value.
Let’s say you invest $10,000 with a 70/30 split between stocks and bonds (which just happens to be my own asset allocation). So you start with $7,000 in stocks and $3,000 in bonds.
Now let’s say that over the course of the year stocks do really well and return 20%, while bonds do poorly and lose 5%. At the end of the year your stock portion would be worth $8,400 and your bond portion would be worth $2,850, for a total value of $11,250. How does that compare to your target percentages?
- Stocks: $8,400/11,250 = 74.7%
- Bonds: $2,850/11,250 = 25.3%
As you can see, simply because of normal market movements your investments have gotten out of balance.
Why should you care about rebalancing?
Okay, so they’re not at the exact percentages you specified, why should you care?
Well, the truth is that you’ll get different answers on both why you should care and how much you should care.
The argument I agree with is that you should care because you picked your asset allocation for a reason. It represents the balance you wanted to strike between risk and return, and deviations away from that asset allocation take you away from your chosen path. Not rebalancing would be like continuing to work extra hours even though the big project has ended. That’s not what you set out to do, so why would you let it continue?
So the next question is how much you should care about rebalancing. In other words, if your asset allocation drifts by just a couple of percentage points, should that matter? If not, how much should you let it drift before taking action?
Again, there are many different opinions here and I haven’t seen anything that definitively says one is better than another.
Because there isn’t a definitive “best” way to do it, my default recommendation would be to check on your investments once per year and rebalance if the percentages are off by more than 5%. Keep in mind that there isn’t a lot of science behind that recommendation, but that’s because there really isn’t a scientific answer to give. In light of that, I think simplicity should be the rule.
If you’re interested in other opinions, there are smart people who will argue that rebalancing is unnecessary, as well as those who advocate for doing it more often.
How to rebalance your investments
By far the simplest way to rebalance your investments is to hold a single fund that is simply a collection of other funds with a target asset allocation. I give examples of this strategy in my article on how to beat 80% of investors with 1% of the effort. With this strategy you don’t even have to worry about rebalancing because the fund handles it for you.
The next best way to rebalance is to do so with your contributions. When you have new money to put into your investments, simply direct it to the part that has decreased in percentage. So in our example above, you would send your contributions to the bond portion of your portfolio, since it was below your target percentage.
You can also rebalance by selling some of one investment and using that money to buy another. In our example above, you would sell some stocks and use the proceeds to buy some bonds. If your money is within a tax-advantaged account like a 401(k) or an IRA, this is a fine approach. But if your money is in a taxable account then you need to be careful with this approach. There may be negative tax consequences to selling that could wipe out any of the benefits of rebalancing. It’s best to seek out advice on your specific situation before doing so.
Balance is important in all aspects of our lives, and it’s no different in investing. If you’ve done the work of choosing a purposeful investment strategy, then it makes sense to rebalance when necessary to make sure you stay on track.