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Wild swings in the stock market can hurt 401(k)s in two ways.
Emotions can take over, spurring bad investment decisions, and an investor’s asset mix can get out of whack, undermining their portfolio’s risk profile and return potential.
But there’s an antidote to that investment portfolio malady: Set up and stick to a rule-driven “rebalancing” strategy devoid of psychological triggers that ensures that your planned mix of stocks and bonds doesn’t veer too far off track.
Hatch a plan to make sure your plan to own, say, 60% stocks and 40% bonds isn’t upended by a dive in stock prices and a corresponding rally in bonds. In the recent bear market, for example, the selloff in stocks shrunk the equity portion of that model portfolio down to about 50%, according to money management firm BlackRock.
That “dramatic drift,” BlackRock told clients in late March, left stock holdings light relative to bonds. To fix that, BlackRock recommended rebalancing portfolios by “buying equities and selling bonds.” The market rebound from the March 23 bear market low, many Wall Street pros say, was powered partly by big institutional investors, such as pension funds, selling bonds to buy stocks to get their asset mixes back on target.
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Taking out fear and greed
Rebalancing is a way to manage risk and smooth out returns over long periods of time. It’s a strategy that helps you buy shares when they’re cheap and sell them when they’re expensive. It takes greed and fear out of the investment equation.
“Having a rebalancing plan ensures you don’t get complacent as one investment rises and becomes an outsized portion of your portfolio, creating greater risk if something goes wrong,” says Kathy Carey, director of investment research and advanced planning at Baird. “(It) ensures that you don’t become spooked in a down market and make a decision to sell at the wrong time.”
Sticking to a long-term asset allocation is key, especially for investors that know the types of returns they need to attain their goals and how much risk they can stomach in order to succeed. Rebalancing is a useful tool to stay on track. And survive rocky periods in markets when volatility spikes.
Here’s a primer on the why, how, and when to rebalance:
Why rebalance your portfolio?
“We believe the most important reason is to take the emotion out of the investment decision,” Carey says. “It can be hard to sell a portion of an investment that has performed well for you and put those funds into something that hasn’t done as well. But this is exactly what you want to do as an investor – buy low and sell high.”
Rebalancing keeps you from getting too greedy or too fearful, adds Brian Sabo, retirement and estate planner at Verdence Capital Advisors.
“The discipline to rebalance helps maintain the long-term risk-and-return objectives of the portfolio,” Sabo says.
How to do it?
You don’t need a Ph.D. in finance to rebalance a portfolio. While many financial planning firms and robo advisers do the rebalancing for you, going the DIY route is easy, too.
The most common way to get a portfolio back to its target allocation is to lighten up on winners and buy more of your losers.
But selling and buying investments isn’t always required, Carey says.
You can “add new cash to the portfolio and put that cash into the portion of the assets you need to increase to get back to your target asset allocation,” Carey says.
Another easy way to rebalance, according to Verdence Capital Advisors, is to first start with a target allocation for each asset class in the portfolio. Then “establish a band – with an upper and lower limit – around the target percentage.”
When either of those upper or lower limits are violated, you rebalance back to your target percentages. So, if your target for U.S. stocks is 50%, your upper and lower band limits would be 60% and 40%. So, if your weighting of domestic stocks climbs to 60%, you’d sell to get back to 50%. And if your holdings shrunk to 40%, you’d buy to get back to 50%.
When to do it?
So, when should you rebalance? There are a few ways to keep your asset mix in-line with your goals. “But it’s more important to have a strategy and stick to it,” Carey says.
You can do it on a predetermined calendar basis, set it in motion during volatile market moves or do it when your asset allocation has gotten out of whack by a certain number of percentage points.
Some rebalancing strategies to consider:
Calendar-driven. At a minimum, you should rebalance your portfolio at least once a year, preferably on about the same date, Carey advises. You could also choose to do so on a more periodic basis, such as quarterly. Let’s use the recently completed first quarter as an example. JP Morgan Funds noted that a portfolio made up of 60% stocks/40% bonds on January 1 would have finished the first quarter with a 53.9% stock weighting and 46.1% in bonds. An investor who rebalances quarterly would sell bonds and buy stocks to get back to a 60/40 portfolio mix.
Rules-driven. An investor can also choose to rebalance when a portion of their portfolio moves away from the target allocation by a certain percentage, typically 5% or 10% or greater,” Sabo says. For example, if an investor determined that a portfolio with 70% global equities and 30% fixed income was appropriate, rebalancing should occur when those targets are either above or below the target weight by as little as 5% or as much as 10%, he says.
Volatility-driven. In the event an asset class, such as the S&P 500, suffers a sizable drop in a short time frame, it could make sense to rebalance during the market fall to take advantage of stocks when they are on sale.
“This past month, the stock and bond markets were extremely volatile providing a good example of when to rebalance,” Sabo says.
Deutsche Bank research shows a good time to raise stock exposure is following a scary period for the market when volatility begins to subside from peak levels. “A moderation in volatility is an important precondition for investors to raise equity exposures,” the bank said in a research report. So, when those days of 5% daily moves start to fade, it’s a good time to rebalance.
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