Investors who wish they were better at buying low and selling high actually have a tool that can force them to do just that. It's called "rebalancing," the practice of regularly re-allocating a portfolio so the investments in it stay in their originally intended proportions.
A 60 percent stocks/40 percent bonds portfolio will get out of kilter if you leave it alone long enough. To rebalance, you have to cut back on the portion that grew - typically the stocks - and add money to the other side. An investor who does that regularly will protect herself from taking more risk than she intends. She also will often lock in gains and buy securities at better prices than she might otherwise.
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Rebalancing is easy for workers who invest through their company 401(k) plan. A one-fund program, such as a target date retirement fund, will be regularly and automatically rebalanced by its managers. Large company retirement plans often let workers leave standing automatic rebalancing orders, so their portfolios can be adjusted quarterly or annually. That works especially well for retirement investors because there are no tax consequences to their rebalancing efforts.
But individual investors who have non-retirement portfolios of their own have to work harder to make rebalancing work. That's because their trades often involve some transaction costs and some tax consequences. And because they may have to rebalance manually, instead of on autopilot. Here's how to do it best.
Don't just stick with the calendar
Welch's firm has software that allow its advisers to monitor portfolios by their asset allocation, but individual investors can watch the same numbers. Set a band of 5 percent or 10 percent, and when one part of your portfolio outgrows its intended allocation by that much, start to think about rebalancing. For example, think 'rebalance' once a 60 percent stock portfolio turns into a 66 percent stock portfolio. Will you miss the top of the market with part of your investments? Yes, but you'll take solid earnings off the table.
If you have to rebalance via a brokerage account that has high transaction fees, rebalance less often. That was the conclusion of a paper published recently in the Journal of Portfolio Management. Bank of America's Merrill Lynch researcher Himanshu Almadi and others said investors facing low costs would do better rebalancing quarterly, those facing higher costs should rebalance once a year.
Plan for tax consequences
It's better to hold taxable securities for at least a full year so they can qualify for lower long-term capital gains tax rates. You can cut your taxes further by selling your losing investments while you're selling your winners, to lock in those losses. You can rebuy the same losing investment in 31 days, or simply buy a similar but different one immediately to complete the rebalancing.
Brian Burmeister, a Denver financial adviser with Charles Schwab's private client group, tells his clients to sell losers before they hit the long-term one-year mark. That way, at tax time they can offset short-term gains and ordinary income, both of which are taxed at higher rates than long-term gains.