Mission Impossible — It's Time to Rebalance

By Scott Lummer
Chief Investment Officer, mPower

(music from Mission Impossible) Bummm bummm bum bum bummm bummm bum bum

I was rock climbing in a remote location when my beeper went off, indicating an urgent e-mail from my boss. After scaling five feet back down to the ground, I read the message, which said that I was to meet him as soon as possible to get instructions for another crucial mission.

The message concluded with a warning that my beeper would self destruct in five seconds, but then again this may have just been the "I love you" virus.

My boss, who looks suspiciously like Anthony Hopkins, gave me my assignment. It seems the Employee Benefit Research Institute has published a study indicating that only 9 percent of 401(k) participants ever rebalance their accounts (adjusting fund investments to their initial allocation proportions). As a result, most of these participants are taking on more risk than they did when they first invested. My boss said that my mission, should I choose to accept it, was to convince as many investors as possible that they should rebalance their fund allocations.

I said I would try, but added that it would be an almost impossible task. He responded, "That's why the column is called Mission Impossible, not merely Mission Difficult." I chided him for using the same line as in the movie, but he correctly pointed out that it was the only good dialogue from the film, and that he'd use it as much as possible.

What Rebalancing Is

Rebalancing is the process of ensuring that fund allocations remain constant. If you don't rebalance, over time the percentage you've allocated to each fund will move away from your initial preference.

This is how it happens: suppose you started this year with your money allocated equally between two funds - half is in the Kidman fund and the other half is in the Cruise fund. The Kidman fund has earned 30 percent to date, while the Cruise fund earned 5 percent. Not due to any allocation changes you've made, but simply to asset growth, you now have 55 percent of your money in the Kidman fund, and only 45 percent in Cruise. To get back to your 50/50 allocation you would have to rebalance by pulling money out of Kidman and into Cruise.

Rebalancing is a vital action if you are to maintain a constant degree of exposure to risk. After a consistent increase in stock market values, if you don't rebalance, you will have a larger proportion invested in stocks than you started with. Of course, that means you have more risk. If you wanted that much risk, one wonders why you didn't start out with that much in equity to begin with.

But if rebalancing is so important, why don't more investors do it? Because on the surface it seems counter-intuitive to rebalance a portfolio. In order to rebalance, you have to reduce the amount invested in the funds that are performing the best, and increase investment in the funds that are doing the worst. The idea of selling your winners and buying more of your losers seems to go against many investors' basic sensibilities.

Does Rebalancing Really Make a Difference?

It is fair to ask how much extra risk you would incur by not rebalancing your portfolio.

Assume you are 60 years old with five years left to retire. Five years ago you invested 50 percent of your money in stocks and 50 percent of your money in short-term bonds. If you never rebalanced your portfolio, you would now have 71 percent in stocks and 29 percent in bonds. How much extra risk is that? Well, if we revisit the 1973 to 1974 market drop, in which stocks fell by 43 percent over a 21-month period, the rebalanced portfolio would lose 22 percent compared to the non-rebalanced portfolio's loss of 31 percent. That means, if you had $500,000 in your nest egg, you would lose $155,000 instead of $110,000, or an additional $45,000 by not rebalancing.

But What about Returns?

This is not to say that risk is always bad. Those of you who have read the articles on the 401Kafé know that we advocate that investors take considerable positions in equities for long-term growth. But a good approach for you, as an individual investor, is to determine how much risk you can take, select an investment strategy commensurate with that risk, and maintain that strategy consistently throughout time. That means maintaining a constant proportion of equities in your plan, instead of letting the market whipsaw your risk around. It's fine if you choose to have 70 percent, or more, in stocks (personally, I have 100 percent in stocks, but I'm probably not retiring for at least 20 years). But make that proportion the result of a conscious decision, and not an artifact of stock market movements.

Mission Completed?

What does all this mean? It means that your mission, which you should choose to accept, is to rebalance your portfolio periodically. That's one of the ways you can prevent your portfolio from self-destructing in five seconds.

Bummm bummm bum bum bummm bummm bum bum

The information provided here is intended to help you understand the general issue and does not constitute any tax, investment or legal advice. Consult your financial, tax or legal advisor regarding your own unique situation and your company's benefits representative for rules specific to your plan.

Mission Impossible — It's Time to Rebalance

By Scott Lummer
Chief Investment Officer, mPower

(music from Mission Impossible) Bummm bummm bum bum bummm bummm bum bum

I was rock climbing in a remote location when my beeper went off, indicating an urgent e-mail from my boss. After scaling five feet back down to the ground, I read the message, which said that I was to meet him as soon as possible to get instructions for another crucial mission.

The message concluded with a warning that my beeper would self destruct in five seconds, but then again this may have just been the "I love you" virus.

My boss, who looks suspiciously like Anthony Hopkins, gave me my assignment. It seems the Employee Benefit Research Institute has published a study indicating that only 9 percent of 401(k) participants ever rebalance their accounts (adjusting fund investments to their initial allocation proportions). As a result, most of these participants are taking on more risk than they did when they first invested. My boss said that my mission, should I choose to accept it, was to convince as many investors as possible that they should rebalance their fund allocations.

I said I would try, but added that it would be an almost impossible task. He responded, "That's why the column is called Mission Impossible, not merely Mission Difficult." I chided him for using the same line as in the movie, but he correctly pointed out that it was the only good dialogue from the film, and that he'd use it as much as possible.

What Rebalancing Is

Rebalancing is the process of ensuring that fund allocations remain constant. If you don't rebalance, over time the percentage you've allocated to each fund will move away from your initial preference.

This is how it happens: suppose you started this year with your money allocated equally between two funds - half is in the Kidman fund and the other half is in the Cruise fund. The Kidman fund has earned 30 percent to date, while the Cruise fund earned 5 percent. Not due to any allocation changes you've made, but simply to asset growth, you now have 55 percent of your money in the Kidman fund, and only 45 percent in Cruise. To get back to your 50/50 allocation you would have to rebalance by pulling money out of Kidman and into Cruise.

Rebalancing is a vital action if you are to maintain a constant degree of exposure to risk. After a consistent increase in stock market values, if you don't rebalance, you will have a larger proportion invested in stocks than you started with. Of course, that means you have more risk. If you wanted that much risk, one wonders why you didn't start out with that much in equity to begin with.

But if rebalancing is so important, why don't more investors do it? Because on the surface it seems counter-intuitive to rebalance a portfolio. In order to rebalance, you have to reduce the amount invested in the funds that are performing the best, and increase investment in the funds that are doing the worst. The idea of selling your winners and buying more of your losers seems to go against many investors' basic sensibilities.

Does Rebalancing Really Make a Difference?

It is fair to ask how much extra risk you would incur by not rebalancing your portfolio.

Assume you are 60 years old with five years left to retire. Five years ago you invested 50 percent of your money in stocks and 50 percent of your money in short-term bonds. If you never rebalanced your portfolio, you would now have 71 percent in stocks and 29 percent in bonds. How much extra risk is that? Well, if we revisit the 1973 to 1974 market drop, in which stocks fell by 43 percent over a 21-month period, the rebalanced portfolio would lose 22 percent compared to the non-rebalanced portfolio's loss of 31 percent. That means, if you had $500,000 in your nest egg, you would lose $155,000 instead of $110,000, or an additional $45,000 by not rebalancing.

But What about Returns?

This is not to say that risk is always bad. Those of you who have read the articles on the 401Kafé know that we advocate that investors take considerable positions in equities for long-term growth. But a good approach for you, as an individual investor, is to determine how much risk you can take, select an investment strategy commensurate with that risk, and maintain that strategy consistently throughout time. That means maintaining a constant proportion of equities in your plan, instead of letting the market whipsaw your risk around. It's fine if you choose to have 70 percent, or more, in stocks (personally, I have 100 percent in stocks, but I'm probably not retiring for at least 20 years). But make that proportion the result of a conscious decision, and not an artifact of stock market movements.

Mission Completed?

What does all this mean? It means that your mission, which you should choose to accept, is to rebalance your portfolio periodically. That's one of the ways you can prevent your portfolio from self-destructing in five seconds.

Bummm bummm bum bum bummm bummm bum bum

The information provided here is intended to help you understand the general issue and does not constitute any tax, investment or legal advice. Consult your financial, tax or legal advisor regarding your own unique situation and your company's benefits representative for rules specific to your plan.