Once you have established and implemented an asset allocation strategy for your 401(k) retirement account based on your savings goal, time horizon, and risk tolerance, it’s important to rebalance your account periodically. Rebalancing simply means adjusting the allocations to the funds in your account back to their original targets. The following guidelines explain why, when, and how to effectively achieve this.
Why?
Over time, the difference in performance between funds in your 401(k) plan can cause your asset allocation to look very different from how they did when you first opened your account. For example, a participant with a 50% stocks/50% bonds allocation at the start of 1995 would have had a 71% stocks/29% bonds allocation five years later if left unattended, due to strong stock market performance during that period. As a result, the participant’s account would have more risk (more stocks) than he or she originally intended. Plus, as the participant would be five years closer to retirement, he or she may want to consider taking on less risk (fewer stocks), not more, in a 401(k). Instead, had the participant periodically rebalanced the account during that period, the risk of having stock holdings out of proportion to what was originally intended would have been greatly reduced.
Let’s take this example a step further and see how it may affect returns. Had the participant rebalanced his or her account back to 50% stocks/50% bonds at the end of each year, the annual return for that period would have only been 1.8% less (18.1% versus 19.9%). But that is a small price to pay for a significant reduction in risk—especially if the participant is nearing retirement.
When?
There are two general approaches to when you should rebalance your 401(k) account. One is to rebalance on a regular time schedule, such as quarterly, semiannually, or annually. This is the easier and more popular method. Simply decide how frequently you want to rebalance and remember your next rebalance date. For example, you can rebalance annually when you receive your year-end 401(k) statement. How frequently you rebalance is not a critical factor since it will not significantly affect your account’s risk and return—so make it easier on yourself and rebalance less frequently (but at least once a year).
The other approach is to rebalance when the allocation is a certain number of percentage points away from its target. For example, the participant with a 50% stocks/50% bonds target allocation might rebalance when stocks are more than 55%, or less than 45%. This method is more difficult because you need to closely monitor fund balances in your account and market conditions may require you to rebalance quite frequently. The approach you decide to use is not important, as long as you diligently follow it.
How?
One way to keep your 401(k) account on track is to make sure your contributions are invested according to your asset allocation target. Then, when you rebalance periodically you should only have to make modest adjustments. To rebalance, simply sell enough of the funds that are above their target and buy enough of the funds that are below their target, until all funds match their target allocation. This means you will be selling some of your recent winners and buying more of your recent losers—but that’s okay—because in asset allocation, today’s winners may be tomorrow’s losers and vice versa. Not only should you diversify among asset classes (stocks, bonds, cash equivalents, etc.), it’s important to rebalance within asset classes. In the case of stocks, for example, you can have a mix of style (value and growth); size (large-, mid-, and small-capitalization); and geographies (U.S., international developed, or emerging markets). Diversification—not putting all your eggs into one basket—may help you better manage risk.
Rebalancing is an important investment management tool available to 401(k) plan participants that is designed to save sufficient assets for retirement. But, like any other tool, proper use is the key to effectiveness. Fortunately, rebalancing is an easy tool to use. Simply determine when and how you plan to rebalance and remember to do it! And if you would feel more comfortable not going it alone, ask a financial advisor for assistance.
This article is for informational purposes only and is not intended as an offer or solicitation for the sale of any financial product or service or as a determination that any investment strategy is suitable for a specific investor. Investors should seek financial advice regarding the suitability of any investment strategy based on their objectives, financial situations, and particular needs. This article is not designed or intended to provide financial, tax, legal, accounting, investment, or other professional advice since such advice always requires consideration of individual circumstances. If professional advice is needed, the services of a professional advisor should be sought. All investments involve risks, including possible loss of principal. There is no assurance that any investment strategy will be successful. Diversification does not ensure a profit or guarantee against a loss.
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