Monday, August 11, 2008

Portfolio rebalancing - buying low and selling high automatically

You probably know the old adage that you should buy low and sell high.  However, did you know that there is an way to make your portfolio automatically do that - even if you are not investing new money?

Suppose you decide that investing 70% of your money into a stock fund and 30% of it into a bond fund is the appropriate asset allocation for your retirement account.  Because these investments will rise and fall at different rates your ratio of 70% stock to 30% bond will not hold.  Properly managed, this is a good thing.  However, if you do not rebalance your account, because your riskier investments tend to grow fastest, your portfolio will slowly expose you to greater risk.

In order to maintain your proper asset allocation, you need to periodically rebalance your portfolio.  In this case, that would involve periodically transferring money from the fund that recently performed the best into the fund that did not perform as well.

In addition to keeping your investment risk at the appropriate level it will force you to buy low and sell high.  If the stock market has a great year you will need to sell some of your stock investment, at this relatively high price, to even things out.  If stocks have a lousy year, you will sell some of your bonds to put more money into the relatively lower priced stock market.
I recommend that you consider establishing a schedule to rebalance your portfolio every 6 - 12 months.  Many investors find it difficult to sell their best performing investment and transfer money into their worst performing investment.  However, doing so is often a very rewarding financial move.  If you have a regular schedule for doing this you can make what could be a difficult, emotional decision into a simple administrative action.

You should also rebalance your portfolio off schedule if the markets have made a dramatic move and you notice that your chosen asset allocation is off by more than a few percentage points.

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