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Is now the time to rebalance? |
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Written by Eric Jonson
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October 27, 2008 |
A reader recently emailed to ask whether he should rebalance his IRA,
which had strayed quite a bit from his intended allocation and risk
level. Long before this year’s steep market decline, he had carefully
determined that his IRA should be invested 60 percent in equity funds
and 40 percent in fixed-income funds. Recently he calculated that the
account balance was 45 percent equity and 55 percent fixed-income.
“I am trying to manage the risk in my portfolio following your suggestions,” he wrote, saying he decided to sell some fixed-income funds and increase his equity holdings. “This is very painful,” he wrote. But he believed that he would benefit in the long run.
Rebalancing is good, a necessary process to keep a portfolio working properly. Rebalancing may or may not produce higher returns, but there is no doubt that it will keep your level of risk under control.
Although the benefit of rebalancing is not an issue in my opinion, the timing sometimes is. There are two schools of thought about this.
One view, which we often recommend to do-it-yourself investors, is to rebalance the portfolio once a year no matter what the market is doing. It doesn’t matter very much whether it happens the first week of January or some other time, as long as it gets done regularly and reliably as a mechanical strategy.
The second view, which we often use with clients, is that (at least in tax-sheltered accounts in which the practice won’t trigger taxable events) a portfolio should be rebalanced whenever its percentage allocations stray significantly from their target percentages. And how do you measure “significantly?” That’s the rub, the very issue that can transform rebalancing from a mechanical science to an art.
It seems obvious, for instance, that a portfolio targeted at 60/40 is not in great need of rebalancing if the equities fall to 58 percent. Yet if the equities fall to 40 percent, that portfolio has a very different level of risk and is overdue for a review.
“Review” is the key word here. We often use rebalancing as an opportunity to talk with clients about their risk tolerance. This year, many people have realized that losses seem much different when they actually happen than when they’re being contemplated in theory during a favorable market period.
Some investors avoid rebalancing because it seems to be throwing good money after bad or “punishing” better-performing assets and “rewarding” laggards. However, reducing portfolio management to emotional equations like that is essentially shooting yourself in the foot.
Still, we are experiencing an unusually volatile market, and restoring an original allocation won’t be right for every investor at this time. If it seems just too uncomfortable, this is an excellent time for a conversation with your adviser.
From his query, I could tell that the reader with the unbalanced IRA had a well diversified portfolio and had carefully determined an allocation appropriate to his risk tolerance. He knew rebalancing would ramp up the level of risk in his portfolio – and he was willing to do that to gain a shot at reaping bigger rewards in a future market recovery.
Because he’s not a client, I didn’t have the opportunity to explore all the relevant issues with him. But I encouraged him to proceed, as it seemed the right thing for him to do, based on the information I had.
If you’d like to read his question and my reply, you’ll find them in the “Ask Merriman” section of our educational web site, www.FundAdvice.com .
Eric Jonson is a financial adviser for Merriman.
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