Primer on Annual Rebalancing

One of the periodic housekeeping chores investors must deal with from time to time is "rebalancing" their portfolios.

It's like four people playing a game of Monopoly. Everybody starts out with 25% of the money, but after a few rounds of play, some are richer and some poorer. To get back where you started, you'd have to "rebalance" by taking money from some players and giving it to others. Here's how that applies to you.

Let's assume you've been following our Upgrading strategy, and allocated your holdings based on our 2008 suggestions for those wishing to follow a portfolio mix of 80% stocks (invest-by-owning) and 20% bonds (invest-by-lending). You divided your money among the five risk categories as suggested in our "asset allocation guidelines" for last year.

In the months that followed, as some funds and categories did better than others, the percentages you started with began to change. How long should you let this continue before you step in and do the buying/selling needed in order to return each category to the desired percentage level? When, in other words, do you rebalance?

We suggest the first week of each new year. Emotionally, January is a good time for new beginnings and fresh starts. Plus, you can take our new allocation guidelines (published every January) into account at the same time.

You will notice that rebalancing may take money away from your better performing categories and give it to poorer performing groups, and vice versa. New investors often question the wisdom of this.

The fact is that market performance leaders change as the economy goes through the various stages of its cycle. For example, the funds in the small/growth group moved from being the worst performing among SMI's five risk categories in 2002 to the best in 2003. Conversely, the small/value group fell from being the top-performer in 2004 to the worst in 2005.

This kind of thing can happen at any time. If it didn't, wouldn't the markets be a great place to make easy money?