Asset allocation and rebalancing: how the mix is set and kept

Asset allocation is the decision about how to divide a portfolio among broad categories of investments, mainly stocks, bonds and cash. Rebalancing is the upkeep: moving money from time to time so the portfolio stays close to the chosen division. Together they shape how much a portfolio's value is likely to swing, which is why they often come up in retirement plan enrollment materials.

What the main asset classes are

• Stocks are ownership shares in companies. Their prices can rise and fall sharply over short periods.
• Bonds are loans to companies or governments that pay interest. Their prices also move, particularly when interest rates change, though generally less sharply than stock prices.
• Cash and cash equivalents include savings deposits and money market funds. Their value is comparatively stable, and the main concern is that inflation can erode purchasing power over time.

The SEC's overview of investment risk describes these tradeoffs in more detail. In general, investments with more potential for gain come with more potential for loss.

The two inputs: time horizon and risk tolerance

The SEC's investor education site calls asset allocation a personal decision that depends mainly on two things.

Time horizon is how long the money will stay invested before it is needed. Someone decades from retirement has more time to wait out a decline than someone who will begin withdrawals next year. People with longer horizons often feel comfortable holding more in volatile investments, and people with shorter horizons often prefer less.

Risk tolerance is a person's ability and willingness to see losses in exchange for the possibility of greater gains. Ability and willingness are different. Ability is financial: income stability, other savings, how soon the money is needed. Willingness is temperament: how a person actually reacts when an account balance drops.

The SEC adds a caution about online risk questionnaires. Their results may be biased toward the products sold by whoever sponsors the site.

Why there is no single correct mix

An allocation that suits one person at one age can be a poor fit for another person, or for the same person later. A job change, a new dependent, an inheritance or an approaching retirement date can all shift either input.

It also helps to look at the whole household. A pension, expected Social Security benefits and a spouse's accounts all affect how much risk a particular account needs to carry. Turning savings into retirement income discusses how these pieces fit together.

Within each asset class, spreading money across many holdings is a separate step, covered in diversification explained.

How a portfolio drifts

Once a mix is chosen, markets begin to change it. The holdings that grow faster become a larger share of the total.

Here is a hypothetical example using round numbers. It is arithmetic, not a prediction.

Nothing was bought or sold in the second row, yet the portfolio is now more exposed to stocks than its owner chose. Restoring the 60/40 mix means moving $6,000 from stocks to bonds. Drift works in the other direction too: after a stock decline, the stock share shrinks and the portfolio becomes more conservative than intended.

Ways to rebalance

There are three basic methods, and they can be combined.

1. Sell and buy. Sell some of the category that has grown and use the proceeds to buy the one that has shrunk.
2. Redirect new money. Point new contributions toward the underweight category until the mix is restored. In a workplace plan this means changing how future contributions are invested.
3. Use withdrawals. People taking money out can draw from the overweight category.

Many workplace plans offer an automatic rebalancing feature that resets the account to chosen percentages on a schedule.

How often

The SEC describes two common approaches: rebalancing on a calendar, such as every six or twelve months, or rebalancing whenever a category moves more than a set percentage away from its target. It notes that either way, rebalancing tends to work best when done relatively infrequently.

Rebalancing can feel uncomfortable, because it means trimming what has recently done well and adding to what has not. Its purpose is to keep risk where the investor set it, not to predict which category will do better next.

Taxes

Taxes depend on the account. Moving money between investments inside a 401(k), a 403(b) or an IRA generally does not create a taxable event. Selling investments that have gained value in a regular taxable account generally does produce a capital gain. For that reason some people do most of their rebalancing inside retirement accounts or by redirecting new contributions. The different account types are described in taxable, tax-deferred and tax-free accounts.

Funds that handle it internally

Some funds do the allocating and rebalancing inside the fund. In a target-date fund, the fund's manager sets the mix, rebalances it and gradually makes it more conservative as a stated year approaches. Balanced funds generally hold a relatively fixed mix and rebalance to it.

These funds remove the maintenance work but not the underlying decision. The investor is still choosing an allocation by choosing the fund, so it is worth knowing what mix the fund holds and how that mix is scheduled to change.

Questions worth asking

• What is the current split among stocks, bonds and cash across all accounts combined?
• Was that split chosen, or is it the result of years of drift?
• When will this money be needed, and has that date changed?
• Does the plan offer automatic rebalancing, and is it turned on?