Rebalancing is the process of periodically resetting your 401(k) account to the asset allocation percentages that you originally set for the account. Rebalancing is necessary because as your investments grow and market conditions change the relative value of the positions in your account will change, sometimes dramatically. Rebalancing is a key way to control risk in a portfolio.
A Simple Example
If you start with a portfolio with 60% in a broad based total stock market index fund and 40% in a total bond market index. Over the next year the stock market goes up 50% (it does happen occasionally) and bonds earn their historical rate of 4%. After one year your portfolio is up a little over 31%.the stock portion of your portfolio is now 68% of your portfolio and bonds are now only 32%. The portfolio is now much more risky than you intended. If nothing is done and a stock market correction occurs the damage to the portfolio will be much greater than you had anticipated and may lead to bad investment decisions.
How Often Should You Rebalance?
Portfolios should be checked for the need to rebalance at least annually. If you are rebalancing on your own a check of the portfolio every quarter is plenty. Most 401(k) platforms now have an auto rebalancing tool that will automatically rebalance your portfolio to your original asset allocation however often you set it. Again, we recommend quarterly. Annually may be sufficient for smaller portfolios and younger investors. Another important strategy to keep a portfolio in balance is to set the asset allocation for new money coming into the portfolio to the same allocation as existing funds. This helps maintain the balance of the positions and reduces the need for small rebalancing trades. Costs also enter into the picture. In most 401(k) plans there are no transaction fees so you can rebalance at no cost. Some plans however, particularly very small plans and those using exchange traded fund (ETF’s) may charge you to make trades. In that case rebalancing should only be done annually or when portfolio positions are more than + or- 5% off target.
Rebalancing and Performance
It should be noted that most academic studies show that effective rebalancing adds only about a quarter percent to performance over time. It is mostly a risk control strategy and a very effective one that can save you a world of worry (and a lot of money) in a major market correction.