Asset allocation, the process of dividing your investments among different types of securities, helps balance the potential risk and reward of your portfolio, though it cannot ensure against loss. Keeping the mix of investments that's right for you involves another essential strategy: rebalancing.

Understanding the Concept

The first step is to allocate your investments among different types of securities given your investment goals, time horizon and risk tolerance. Over time it's likely that outside factors, such as volatile market conditions or changing interest rates, will cause your allocation to veer off course from the percentages you set for each investment type.

For example, you may have decided to invest 60% of your portfolio in stocks, 30% in bonds and 10% in money market securities. If market activity causes the value of the stock portion of your portfolio to increase significantly, you'll have a greater percentage of your portfolio invested in stocks than you intended and less invested in bonds and money markets.

Rebalancing gets your portfolio back to your desired 60/30/10 percentage mix. This simply means that you should make adjustments (explained further below) to bring your portfolio back in line with your asset allocation plan. This ensures your portfolio maintains the balance of risk and return you've determined is right for your goals.


Knowing How to Rebalance

Now that you know about rebalancing, how do you actually go about doing it? The easiest explanation is that to get your investments back on track with your intended asset allocation, you have to sell the type of investment that has been performing well and buy the type of investment that hasn't been performing as well.

This may sound confusing and investors often make the mistake of doing the opposite-selling an investment when it isn't performing well and buying one that has performed well in the recent past. This means you may be selling low and buying high, which is the reverse of the common investment advice to "buy low and sell high."

Here's an example of how to rebalance your portfolio, using the same 60/30/10 portfolio mix mentioned above. Say that stocks have performed exceptionally well in the past year and the value of the stock portion of your portfolio has increased enough to account for 70% of your portfolio. And bonds haven't performed well, causing the value of the bond portion of your portfolio to decrease to 20%.

To get back to your original allocation, you'd have to sell some of your stock investments and use the proceeds to buy more of your bond investments. You can either make these transactions all at once, or little by little. For example, with a 401(k) account, you may be able to change your future allocations (contribute more of your money going forward to bond investments and less to stock investments) to reach the same result.

Rebalancing also involves some careful analysis of the investments you own. If the value of a particular investment is consistently down, take a close look to make sure it's still a good investment for your portfolio. You also need to make sure your original asset allocation still makes sense based on your investment time horizon and tolerance for risk.


Setting a Regular Timetable

Experts disagree on how often to rebalance an investment portfolio, but all agree it should be done on a regular basis. This decision should be made based on your individual circumstances and investments.

For starters, it's always a good idea to review your portfolio at least once a year. When you conduct your annual portfolio review, rebalance at that time if you need to get your portfolio back to your target mix of investment types. If your investments are in taxable accounts, any taxable gains resulting from the sale of investments you owned for more than a year will be long term and subject to lower tax rates than short-term capital gains.

Some experts say that you should watch your portfolio more closely and rebalance each quarter as needed. This may be a better approach for a 401(k) account or an IRA since you won't have to worry about the tax consequences of frequent transactions.


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This information is for educational purposes only and not intended as tax advice. Please consult your tax advisor for more detailed information or for advice regarding your individual situation.