TheAutomatic Approach

Automatically rebalancing suggests that you rebalance your portfolio at the same time each year, to its starting target allocation, regardless of market conditions. It works like this:

Assume your allocation is 50 percent stocks/50 percent bonds. In years when the stock market is doing well, as equity values swell, your account may grow to 60 percent stocks/40 percent bonds. Rebalancing forces you to take profits from equities and buy bonds.

On the flip side, after bear markets, with equity values shrinking, your allocation may morph into 40 percent stocks/60 percent bonds. Rebalancing will force you to sell bonds and buy equities at bargain prices.

For most investors, this disciplined approach works best, and rebalancing once a year makes the most sense.

Investors taking a more active role should rebalance after periods of extreme returns in the market (equities up in excess of 20 percent), or just after times when you have experienced excess market losses (equities down more than 20 percent). This will force you to sell high and buy low.

This active approach is manual. Rather than rebalancing at the same time each year, the shift must be investor initiated and is  based on market conditions. Using this approach may mean you only rebalance every other year, after extreme market moves, rather than automatically at a set time.

For an added twist, instead of rebalancing to the starting target allocation, use the two rebalancing guidelines below to force yourself to buy more equities when the market is down and sell more equities when the market is up.

During bear markets, people’s appetite for risk decreases. They only like risk when it is working in their favor, so a decision is often made to rebalance to a more conservative allocation.

If the equities had been 70 percent, perhaps the investor decides he only wants 50 percent of his portfolio in equities. In this way, investors hurt themselves by selling low and abandoning their well thought out strategy at the worst possible time.

I would suggest that a decision be made to  only rebalance to a more conservative portfolio after a year of excess equity returns.

At year end, if equity markets are up 15 percent or more, that would be the time to consider rebalancing to a more conservative allocation.

If you are within five years of retirement, accelerate this plan. Instead of waiting until a year where the market is up 15 percent, shift assets to a more conservative allocation years when the market is up 10 percent.

The time to buy is when everyone else is selling. After extreme bear markets, consider increasing, rather than decreasing, your equity holdings.

At year end, if equity markets are down 15 percent or more, that would be the time to rebalance to a more aggressive allocation. Once markets recover, use Rebalancing Guideline 2 to tell you

If you are within 10 years of retirement, take caution when using this guideline, or scrap it all together. If you do implement it, only become more aggressive if equity markets are down in excess of 25 percent. And then be quicker to rebalance back to a more conservative allocation after markets recover.