Book review: Bogleheads on rebalancing

Welcome to this week's review of another chapter in The Bogleheads’ Guide to Investing. This week we're looking at Chapter 17: Track Your Progress and Rebalance When Necessary.

If you're just joining us, please visit JLP's page on The Bogleheads' October Project to read the reviews of Chapters 1-16.

At this point in the book, authors Larimore, Lindauer and LeBeouf (can you say that ten times fast?) have laid out many of the basics of investing in Part 1, Essentials of Successful Investing. By now, if you've been following their advice, you've already put in place many of the foundations of successful investing. You're living within your means. You've put a savings plan in place. You've determined your financial goals. You've decided upon an asset allocation based on your goals, and you've researched low-cost, tax-efficient investments within each asset class. You have chosen a financial advisor or decided to be your own advisor, and you've put your money into all the appropriate pots.

What next? Now it's your job to make sure that your well-laid plans continue to run smoothly until you successfully arrive at each of your financial goals and milestones.

Chapter 17 marks the beginning of Part 2, Follow-Through Strategies to Keep You on Target. It deals with one of the most important regular maintenance activities that successful investors engage in: Rebalancing investments to maintain the desired asset allocation.

Rebalancing becomes necessary when some of your assets outperform others. The chapter lays out a sample portfolio and illustrates how it will naturally become imbalanced through the normal ups and downs of the markets. For simplicity's sake, let's say you start out with 50% of your assets in stocks, and 50% in bonds. Over time, your 50-50 balance will be upset because the two asset classes will not perform exactly the same. You need to regularly sell assets that have grown out of proportion with your desired allocation and buy assets that have lagged in order to maintain the level of risk you decided upon when you created your original asset allocation. The authors also offer compelling arguments for why portfolios that are regularly rebalanced perform better over the long term. If you don't rebalance, you're taking on more risk and it's very unlikely your higher risks will be justified by better returns.

Okay, we're all convinced. Now how and when do we rebalance our portfolios?

1. Track your porfolio
The authors lay out many software solutions for tracking changes in your portfolio with an eye toward maintaining your desired asset allocations. If you're not computer savvy, they say, you should look for an investment company that will provide asset allocation tracking information on regular paper statements. I myself have a sister who has tracked her asset allocation quite successfully for 20 years using nothing more sophisticated than a paper, pencil and calculator. The key is to find a method that works for you and that you are likely to maintain long-term.

2. Decide on a trigger that will cause you to rebalance
There are two main strategies people use for rebalancing. Some people decide on a margin of error, called an expansion band, after which they'll rebalance. This means that if their asset allocations in any category are off by more than, say, 5%, they'll rebalance. This method requires fairly regular tracking so you'll know when it's time to follow through on your rebalancing plan.

The other main method is to rebalance at regular intervals regardless of market performance. Some investors choose to rebalance monthly, quarterly, semi-annually, annually, or even less regularly. There are two main determinants for deciding how often to rebalance. The first is taxes. Because gains on securities are taxed more heavily if you've owned shares for less than 12 months, there are strong arguments against rebalancing more often than every 12 months. The second factor requires self-knowledge. What kind of schedule will be the most likely to help you stick to your asset allocation strategy? The authors lay out some examples of how different investor personalities might be better served by different rebalancing strategies.

3. Figure out how much money to move around.
The authors provide a nifty chart that you can plug your own numbers into to figure out how much money needs to be deducted from high-performing asset classes and moved into underperformers in order to get back to that desired allocation.

4. Ready, set...rebalance.
Here's where the authors explain different ways to actually rebalance. A few highlights:

The obvious: Sell off part of your winning assets and put the money into less stellar performers. Don't forget to look carefully at costs associated with taxes and transaction fees before you do this.

If you're already drawing down the account, take your next withdrawals from the asset class that's had a big run-up recently.

If you're actively adding to the account, direct new deposits into funds whose balances have dipped below your targets.

Change the preferences on your accounts so that distributions go into a cash-management account (such as a money-market account) instead of being reinvested in the same fund. That way, you can funnel distributions from high performing funds into other funds in asset classes that are lagging.

Let someone else rebalance for you. A portfolio manager will watch your accounts and rebalance when necessary for a premium. Not surprisingly, the authors tout Vanguard's Asset Management Service (Bogleheads tend to favor John Bogle's company, Vanguard).

Buy a fund-of-funds that has an asset allocation comparable to your desired allocation, and let the fund managers keep tabs on when rebalancing is necessary. Many of these funds also have a built-in target date (such as the date retirement or college entrance is expected), and change their asset allocations to a more conservative mix as you get closer to the date you'll need the funds. These funds are available from many big fund families (Fidelity, T. Rowe Price, Vanguard, TIAA-CREF, etc).

This concludes my review of Chapter 17 of The Bogleheads’ Guide to Investing. If you are a beginning investor, or an investor with a moderate amount of experience who wants to learn from a group of people whose ideas are backed by solid research and experience, I would recommend this book.

Chapter 18 will be reviewed tomorrow by Jonathan of My Money Blog. If you aren't familiar with his blog, take a look around. It's one of my favorites.

Related posts:
Asset allocations nearing completion