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If you're like most Americans, you
probably haven't bought or sold any of the funds in your 401(k) plan since the day you set
it up. If this is the case, you're probably cheating yourself out of better returns in
your portfolio.
What many workers don't realize is that they
need to regularly rebalance their 401(k) portfolio to stay within their risk level and to
protect against potentially huge losses.
There's an old saying that goes "do anything long
enough and it becomes a habit."
Billie Moore wants to pick up the habit of rebalancing her
401(k) account. For the past seven years, her money lingered untouched in her account.
Then, when a departing co-worker revealed her 401(k) balance, Moore, 52, took a look at
her own account and found it suffered from two problems: an uninformed initial allocation
and lack of regular rebalancing.
Part of her problem stemmed from a lack of education.
"I never knew I could have gone in and (re)allocated," she said. If she had done
this, she would have noticed her initial error, quickly corrected it and got her portfolio
on the right track years ago.
Moore's case, unfortunately, is common among American
workers. They make an initial allocation, sometimes mistakenly, and then ignore the
account, save checking to see that the balance is rising.
"Eighty percent of people don't rebalance," said
David Wray, president of the Profit Sharing/401(k) Council of America. "We feel
strongly that one of the education propositions we need to get to people is that they need
to rebalance."
"Rebalancing quarterly can add as much as another half
percent of return a year," said Joel Ticknor, certified financial planner and
president of Ticknor Financial Inc. in Reston, Va.
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"Rebalancing is psychologically
difficult to do. You are selling what has been doing best."
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| — Scott Leonard,
certified financial planner, Leonard Capital Management. |
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Before we go any further, let's make sure you don't confuse
rebalancing with reallocation. They are two totally different concepts. Many financial
planners disapprove of frequent 401(k) asset reallocation, whereas they warmly encourage
regular rebalancing. Reallocation is when you change the percentage of assets invested in
different asset classes. Rebalancing is when you sell or buy funds in your plan so that
your asset allocation percentages remain consistent.
The Initial Allocation
Hopefully, before you began contributing to a 401(k), you
took some time to think about what your retirement would be like: Where you'll live, what
your monthly bills will be, what your sources of income will be ... questions of this
nature.
Based on the answers, you should have carefully created an
asset allocation strategy that will help you reach your retirement goals. Part of that
planning process should have included researching the investment options offered in your
401(k) plan and selecting a mix that would give you the highest probability of reaching
your retirement goal at the lowest risk. The best way to reduce your risk is by
diversifying your investments across several asset classes: bonds, equities and/or cash.
To read about developing an initial asset allocation
strategy, visit The Value of Asset Allocation.
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| More Info |
| When you rebalance, you are automatically
selling high and buying low. You are selling the funds that have done the best, while
buying funds that aren't doing so well. "What rebalancing forces you to do is to
adhere to your investment strategy by selling high and buying low," said Joel
Ticknor, certified financial planner and president of Ticknor Financial Inc. in Reston,
Va. |
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Keep In Balance
Rebalancing is simply readjusting your portfolio back to
the original asset allocation that took into account your risk tolerance and your time
horizon.
"I tell clients that the academic research shows that
rebalancing is the closest thing to a free lunch on Wall Street," Ticknor said. He
and other planners explain that rebalancing tends to reduce the volatile swing in
portfolio returns. He cites academic studies that show rebalancing can add an additional
half percent return. Ticknor based his opinion on the study "Efficient Portfolio
Rebalancing," authored by Truman Clark, and published by Dimensional Fund Advisors
Inc. of Santa Monica, Calif.
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"I tell clients that the academic
research shows that rebalancing is the closest thing to a free lunch on Wall Street."
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| — Joel Ticknor,
certified financial planner and president of Ticknor Financial Inc. |
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Suppose you invested money in 1976 and initially allocated
60 percent of your portfolio to equity funds and 40 percent to bond funds. If you never
rebalanced the account, today nearly 85 percent of your assets would be in equity funds
and about 15 percent in bond funds because stocks posted higher returns over that time
period. While your account would have posted strong returns, those profits would come at a
higher risk level than you originally selected. And, more importantly, you would be
subjecting your retirement money to potentially huge losses should equity funds take a
dive.
Rebalancing may entail selling a fund that is doing better
than you expected; a fund that is skewing your risk level.
Yes, it's counterintuitive, planners say. "Rebalancing
is psychologically difficult to do. You are selling what has been doing best," said
Scott Leonard, a certified financial planner and owner of Leonard Capital Management of El
Segundo, Calif.
If you don't rebalance and one asset class in your
portfolio becomes too large, you are by default changing your risk profile.
"What rebalancing forces you to do is to adhere to
your investment strategy," Ticknor said.
Rebalancing How-to
Financial planners recommend you rebalance at least once a
year and no more than four times a year. One easy way to do it is to pick the same day
each year or each quarter, and make that your day to rebalance. By doing this, you will
distance yourself from the emotions of the market, Wray said.
Moore said she might rebalance quarterly. "These
allocations I have … have given me a starting point so I can look at percentage of
return," she said. "I'll get my first statement in October. That won't be enough
time. I'll look closely in January."
Further, many planners recommend you don't rebalance unless
your portfolio is off balance by 5 percent or more.
You don't need to be a financial whiz to learn how to
rebalance; you can do it with a pencil and paper.
If your account statement includes a pie chart showing how
your money is invested, it's easy to figure out if you need to rebalance and how to do it.
Suppose you initially allocated 40 percent of your portfolio to bond funds and 60 percent
to equity funds. Further suppose that when you get your next statement, it shows that 70
percent of your assets are in equity funds and 30 percent are in bond funds. To stay
within your acceptable risk level, you should sell enough equity funds to bring that back
to 60 percent of your assets and buy enough bond funds to bring them up to 40 percent of
assets.
If you don't have a pie chart, you need to look at the
balance of all your investments in the 401(k) plan. Calculate what percentage each
represents of the total value, and then sell shares from the categories that are too large
and buy shares in the categories that are too small until you are back in line with your
original asset allocation percentages.
Should I Reallocate?
Reallocation is a different sort of readjustment; one in
which you change the asset allocation percentages you originally selected in your plan.
There are two general reallocation strategies: life-style
reallocation and tactical or market-timing reallocation.
Older workers and retirees who are close to reaching their
retirement goals and want to reduce their portfolio's risk often do life-style
reallocation. Commonly, they reduce their holdings in equities and boost their holdings of
bonds and cash as they get older so their portfolio won't have as much volatility.
Hopefully "when you reach your 50s, you should have
accumulated a substantial amount of money," said Wray. "People need to reassess
at that point."
This type of reallocation should be accompanied by a
careful reassessment of your goals, risk tolerance and your progress. In other words, you
need to go through the entire planning process beginning at square one. "Folks need
to rewrite their investment policy statement, saying 'here's what we are doing long
term,'" said Scott Leonard.
Billie Moore reallocated her 401(k) plan in August because
she never selected the correct funds in the first place, being 100 percent invested in
money-market mutual funds.
The friend that told her about rebalancing also helped her
figure out how to reallocate her funds. Moore took her 401(k) money and split it so that
10 percent of her assets are in money-market funds, 30 percent in bond funds and 60
percent in equity funds.
The second type, tactical reallocation, is the one that
draws most financial planners' ire because it's based on market timing. This is when you
decide to divert part of your portfolio to a particular asset class because it's hot.
In 1999, there was no hotter stock market sector than
technology. As measured by the Standard & Poor's 500 Technology Index, the sector
posted a 35.62 percent return.
Suppose you created a retirement portfolio that promised a
steady 9 percent annual return. It would be tough to stick with that plan, especially if
all your friends were bragging about their tech stock winners. Adding to the peer pressure
is today's financial media, constantly touting winning funds, winning stocks and winning
sectors.
Most of us want to be invested in the hot performer. We'd
look at our portfolio and see which sectors have been doing poorly: bonds, for instance.
So, we'd sell our bond funds and buy the tech stock fund. We would reallocate.
That would be the wrong thing to do, planners say.
"Don't do tactical reallocation," said Greg Curry, certified financial advisor
and president of Pillar Financial Advisors in Louisville, Ky. "You really have to be
a psychic" to win.
One of the basic goals of asset allocation is to develop a
diversified portfolio that will continue to make money no matter the economic conditions.
Hence, you would have invested in dissimilar assets to create your portfolio. When you
made your initial asset allocation, you assumed that when your investment in stock funds
did well, your bond funds would likely do poorly. And, vice versa.
"The minute you start deviating (from your original
allocation) and start trying to make decisions on what you think the market will do in the
short term, the probability of reaching the goal diminishes. You put yourself in the
position of taking on a lot more risk," Wray said.
Ticknor offers some insight as to why people don't stick
with their plan. "Most of the problem with individual investors is they act
emotionally to events over which they have no control," he said.
He said that recent studies show that individuals who
actively managed their accounts only earned half of the rate of return that the market
generated. "It's that buying and selling that keeps them out of the market and
degrades their return," Ticknor said.
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