Wednesday, January 20, 2016

Reminder: Time To Rebalance Your 401(k)

The start of a new year is a natural time to reflect on where you've been, where you want to go, and how you want to get there. It also is a good time to revisit things you don't pay much attention to - specifically your 401(k).

Once you start participating in a 401(k), it's easy to forget about it. It's one of those things that you set up once and then don't look at again. This can be a good thing. If you aren't constantly checking on it, you're not going to be bothered by the inevitable ups and downs that occur with any stock market investment. You won't be tempted to try to time the market, which almost guarantees a loss.

But once a year it pays to take a look at the asset allocation in your 401(k) and make sure it's still where you want it. Over the past year, some market segments and funds may have had a great run and now represent a larger portion of your portfolio than you want. For example, suppose you want 20% of your 401(k) money invested in mutual funds that invest in small cap companies. If small caps had a great year last year, those mutual funds may have gone up quite a bit in value and they now might comprise 25% or more of your portfolio. That's more exposure to small caps than you wanted, so you need to bring that back down to your 20% target.

Here's what my target allocation is and what my actual fund allocation is:

My target allocation

My actual allocation

As you can see, my actual allocation is not too far from my  target allocation - the largest difference is about 0.2%. This is because my company switched 401(k) providers in June and so I've only had this allocation for six months. Had I been in these funds for a full year, there would likely be a greater divergence.

The process of changing your actual allocation back to match your target allocation is called asset allocation rebalancing and almost every 401(k) company provides a tool that allows you to do this easily. Some even let you set up an automatic rebalancing schedule so you don't even have to do this once a year. That truly makes your 401(k) a set-and-forget option! I've got that option in my plan. Here's what it looks like:

Set the percentages to what you want

What Rebalancing Is

When you rebalance your portfolio, what you are doing in managing risk. You are selling some of your positions that have appreciated in value and buying more of those that have underperformed. This may seem counter-intuitive. Why would you sell stocks that are rallying and buy ones that are falling? Because the stock market is cyclical. Specific stocks or market segments will not always continue to rise. Likewise, those that are falling will not always continue to fall. By rebalancing your portfolio regularly, you can average out those cycles. Rebalancing helps ensure you sell high and buy low, always a winning strategy.

What Rebalancing Is Not

As you might have guessed, rebalancing can reduce your overall performance. When you sell your appreciated assets, you are missing out on any future appreciation that might happen. But not really. After all, you're not going to sell all your appreciated assets, just some of them. If the mutual fund or market sector continues to rise, you'll still get some of that gain, just not as much as if you didn't rebalance. Rather than think of the gains you might miss, think of it the other way around - think of the losses you may avoid. When the market sector drops (and it will at some point), you won't get hit with as much of that loss.

How Often Should You Rebalance?

Some people advocate rebalancing anytime your asset allocation deviates from your target allocation percentage by 5%. Some suggest doing it every quarter. Both those options seem rather frequent to me. There's no harm in doing it that often, but it involves paying more attention to your 401(k) than most people do. (Also note that, as you can see in the screenshot above, some funds might charge you a fee for excessive selling, so you probably don't want to do this too often.)  Since I'm posting this at the beginning of the year, you can probably guess what my recommendation is. Rebalancing once a year still provides the benefits of the process and yet is infrequent enough that you don't always have to worry about remembering to do it.

Remember, you are investing for the long term. You don't need to chase gains or beat the market. A boring, conservative investment strategy will make you a millionaire. You don't need to time the market. You just need to be in the market.


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