Boost Your IRA Returns by Rebalancing

By Clifton Linton
Senior Writer, mPower

In This Story The Initial Allocation Keep In Balance Rebalancing How-to Should I Reallocate?

If you're like many Americans, you probably haven't bought or sold any of the funds in your IRA since the day you set it up. If you haven't, you're probably cheating yourself out of better returns in your portfolio.

What many investors don't realize is that they need to regularly rebalance their IRA accounts to improve profits and stay within their risk level.

minute: read this article at a glance.

Technical Terms Risk tolerance Time horizon S&P 500

In some ways, IRAs are a little like house plants. Both are generally low maintenance. But, with a bit of nurturing, they can produce healthy results.

For an IRA account to grow and flourish, it needs regular contributions and periodic rebalancing.

Yet, according to anecdotal evidence, most people only give their IRAs the contributions. They don't rebalance. Most commonly, workers make an initial allocation and then ignore the account, save checking to see that the balance is rising. As a result, their accounts don't reach their full potential, financial planners say.

Rebalancing "tends to give you extra return," said Greg Curry, certified financial advisor and president of Pillar Financial Advisors in Louisville, Ky.

"Rebalancing is psychologically difficult to do. You are selling what has been doing best." — Scott Leonard, certified financial planner, Leonard Capital Management.

Before we go any further, let's make sure you don't confuse reallocation with rebalancing. They are two totally different concepts. Many financial planners disapprove of frequent reallocation, whereas they warmly encourage regular rebalancing. Reallocation is when you change the percentage of assets invested in different asset classes. Rebalancing is when you sell or buy holdings in your account so that your asset allocation percentages remain consistent.

The Initial Allocation

Hopefully, before you began contributing to an IRA, you took some time to think about what your retirement would be like: Where you'll live, what your monthly bills will be, what your sources of income will be ... questions of this nature.

Based on the answers, you should have carefully created an asset allocation strategy that will help you reach your retirement goals. Part of that planning process should have included researching the investment options offered for IRAs and selecting a mix that would give you the highest probability of reaching your retirement goal at the lowest risk. The best way to reduce your risk is by diversifying your investments across several asset classes: bonds, equities and/or cash.

To read about developing an initial asset allocation strategy, visit The Value of Asset Allocation.

More Info When you rebalance, you are automatically selling high and buying low. You are selling the funds that have done the best, while buying funds that aren't doing so well. "What rebalancing forces you to do is to adhere to your investment strategy by selling high and buying low," said Joel Ticknor, certified financial planner and president of Ticknor Financial Inc. in Reston, Va.

Keep In Balance

Rebalancing is simply readjusting your portfolio back to the original asset allocation that took into account your risk tolerance and your time horizon.

"I tell clients that the academic research shows that rebalancing is the closest thing to a free lunch on Wall Street," Ticknor said. He and other planners explain that rebalancing tends to reduce the volatile swing in portfolio returns. He cites academic studies that show rebalancing can add an additional half percent return. Ticknor based his opinion on the study "Efficient Portfolio Rebalancing," authored by Truman Clark, and published by Dimensional Fund Advisors Inc. of Santa Monica, Calif.

Remember, when you rebalance, you are readjusting your portfolio back to the original mix that took into account your risk tolerance and your time horizon.

"I tell clients that the academic research shows that rebalancing is the closest thing to a free lunch on Wall Street." — Joel Ticknor, certified financial planner and president of Ticknor Financial Inc.

This may entail selling a fund that is doing better than you expected; a fund that is skewing your risk tolerance.

Yes, it's counterintuitive, planners say. "Rebalancing is psychologically difficult to do. You are selling what has been doing best," said Scott Leonard, a certified financial planner and owner of Leonard Capital Management of El Segundo, Calif.

If you don't rebalance and one asset class in your portfolio becomes too large, you are by default changing your risk profile. Consequently, while you may make greater returns, you might also suffer greater losses.

"People don't want to make changes when things are going well," said Ed Slott, CPA and editor of Ed Slott's IRA Advisor newsletter. Many people with large IRA balances today got them by allowing the equity portion of their IRAs to grow unchecked, Slott speculates. "That's why you don't see a lot of rebalancing," he said.

Suppose you invested money in 1976 and initially allocated 60 percent of your portfolio to equity funds and 40 percent to bond funds. If you never rebalanced the account, today nearly 85 percent of your assets would be in equity funds and about 15 percent in bond funds because stocks posted higher returns over that time period. While your account would have posted strong returns, those profits would come at a higher risk level than you originally selected. And, more importantly, you would be subjecting your retirement money to potentially huge losses should equity funds take a dive.

Here's how it works: When you rebalance, you are automatically selling high and buying low. You are selling the funds that have done the best, while buying funds that aren't doing so well.

"What rebalancing forces you to do is to adhere to your investment strategy," Ticknor said.

Rebalancing How-to

Financial planners recommend you reallocate at least once a year and no more than four times a year. One easy way to do it is to pick the same day each year or each quarter, and make that your day to rebalance. By doing this, you will distance yourself from the emotions of the market, Wray said.

Many planners recommend you don't reallocate unless your portfolio is off balance by 5 percent or more.

You don't need to be a financial whiz to learn how to rebalance, you can do it with a pencil and paper.

If your account statement includes a pie chart showing how your money is invested, it's easy to figure out if you need to rebalance and how to do it. If you don't have a pie chart, you need to look at the balance of all your investments in the IRA. Calculate what percentage each represents of the total value, and then sell shares from the categories that are too large and buy shares in the categories that are too small until you are back in line with your original asset allocation percentages.

Should I Reallocate?

Reallocation is a different sort of readjustment; one in which you change the asset allocation percentages you originally selected in your account.

There are two general reallocation strategies: life-style reallocation and tactical or market-timing reallocation.

Older workers and retirees who are close to reaching their retirement goals and want to reduce their portfolio's risk often do life-style reallocation. Commonly, they reduce their holdings in equities and boost their holdings of bonds and cash as they get older so their portfolio won't have as much volatility.

"When you reach your 50s, you should have accumulated a substantial amount of money," said Wray. "People need to reassess at that point."

This type of reallocation should be accompanied by a careful reassessment of your goals, risk tolerance and your progress. In other words, you need to go through the entire planning process beginning at square one. "Folks need to rewrite their investment policy statement, saying 'here's what we are doing long term,'" said Leonard.

Read More How to accurately measure your fund's performance.

The second type, tactical reallocation, is the one that draws most financial planner's ire because it's based on market timing. This is when you decide to divert part of your portfolio to a particular asset class because it's hot.

In 1999, there was no hotter stock market sector than technology. The sector posted a 35.62 percent return last year, according to the Standard & Poor's 500 Technology Index. Many investors leapt into this sector, which posted a whopping 206.45 percent cumulative return over the last three years.

Suppose you created a retirement portfolio that promised a steady 9 percent return. It would be tough to stick with that plan, especially if all your friends were bragging about doing better with their tech stocks. Adding to the peer pressure is today's financial media, constantly touting winning funds, winning stocks and winning sectors.

Most of us want to be invested in the hot performer. We'd look at our portfolio and see which sectors have been doing poorly: bonds, for instance. So, we'd sell our bond funds and buy the tech stock fund. We would reallocate.

That would be the wrong thing to do, planners say. "Don't do tactical reallocation," said Greg Curry, certified financial advisor and president of Pillar Financial Advisors in Louisville, Ky. "You really have to be a psychic" to win.

One of the basic goals of asset allocation is to develop a diversified portfolio that will continue to make money no matter the economic conditions. Hence, you would have invested in dissimilar assets to create your portfolio. When you made your initial asset allocation, you assumed that when your investment in stock funds did well, your bond funds would likely do poorly. And, vice versa.

Related Reading The Value of Asset Allocation Your Guide to Understanding IRA Fees Stay in Your Protective Shell

"The minute you start deviating (from your original allocation) and start trying to make decisions on what you think the market will do in the short term, the probability of reaching the goal diminishes. You put yourself in the position of taking on a lot more risk," Wray said.

Ticknor offers some insight as to why people don't stick with their plan. "Most of the problem with individual investors is they act emotionally to events over which they have no control," he said.

He said that recent studies show that individuals who actively managed their accounts only earned half of the rate of return that the market generated. "It's that buying and selling that keeps them out of the market and degrades their return," Ticknor said. 

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.

Boost Your IRA Returns by Rebalancing

By Clifton Linton
Senior Writer, mPower

In This Story The Initial Allocation Keep In Balance Rebalancing How-to Should I Reallocate?

If you're like many Americans, you probably haven't bought or sold any of the funds in your IRA since the day you set it up. If you haven't, you're probably cheating yourself out of better returns in your portfolio.

What many investors don't realize is that they need to regularly rebalance their IRA accounts to improve profits and stay within their risk level.

minute: read this article at a glance.

Technical Terms Risk tolerance Time horizon S&P 500

In some ways, IRAs are a little like house plants. Both are generally low maintenance. But, with a bit of nurturing, they can produce healthy results.

For an IRA account to grow and flourish, it needs regular contributions and periodic rebalancing.

Yet, according to anecdotal evidence, most people only give their IRAs the contributions. They don't rebalance. Most commonly, workers make an initial allocation and then ignore the account, save checking to see that the balance is rising. As a result, their accounts don't reach their full potential, financial planners say.

Rebalancing "tends to give you extra return," said Greg Curry, certified financial advisor and president of Pillar Financial Advisors in Louisville, Ky.

"Rebalancing is psychologically difficult to do. You are selling what has been doing best." — Scott Leonard, certified financial planner, Leonard Capital Management.

Before we go any further, let's make sure you don't confuse reallocation with rebalancing. They are two totally different concepts. Many financial planners disapprove of frequent reallocation, whereas they warmly encourage regular rebalancing. Reallocation is when you change the percentage of assets invested in different asset classes. Rebalancing is when you sell or buy holdings in your account so that your asset allocation percentages remain consistent.

The Initial Allocation

Hopefully, before you began contributing to an IRA, you took some time to think about what your retirement would be like: Where you'll live, what your monthly bills will be, what your sources of income will be ... questions of this nature.

Based on the answers, you should have carefully created an asset allocation strategy that will help you reach your retirement goals. Part of that planning process should have included researching the investment options offered for IRAs and selecting a mix that would give you the highest probability of reaching your retirement goal at the lowest risk. The best way to reduce your risk is by diversifying your investments across several asset classes: bonds, equities and/or cash.

To read about developing an initial asset allocation strategy, visit The Value of Asset Allocation.

More Info When you rebalance, you are automatically selling high and buying low. You are selling the funds that have done the best, while buying funds that aren't doing so well. "What rebalancing forces you to do is to adhere to your investment strategy by selling high and buying low," said Joel Ticknor, certified financial planner and president of Ticknor Financial Inc. in Reston, Va.

Keep In Balance

Rebalancing is simply readjusting your portfolio back to the original asset allocation that took into account your risk tolerance and your time horizon.

"I tell clients that the academic research shows that rebalancing is the closest thing to a free lunch on Wall Street," Ticknor said. He and other planners explain that rebalancing tends to reduce the volatile swing in portfolio returns. He cites academic studies that show rebalancing can add an additional half percent return. Ticknor based his opinion on the study "Efficient Portfolio Rebalancing," authored by Truman Clark, and published by Dimensional Fund Advisors Inc. of Santa Monica, Calif.

Remember, when you rebalance, you are readjusting your portfolio back to the original mix that took into account your risk tolerance and your time horizon.

"I tell clients that the academic research shows that rebalancing is the closest thing to a free lunch on Wall Street." — Joel Ticknor, certified financial planner and president of Ticknor Financial Inc.

This may entail selling a fund that is doing better than you expected; a fund that is skewing your risk tolerance.

Yes, it's counterintuitive, planners say. "Rebalancing is psychologically difficult to do. You are selling what has been doing best," said Scott Leonard, a certified financial planner and owner of Leonard Capital Management of El Segundo, Calif.

If you don't rebalance and one asset class in your portfolio becomes too large, you are by default changing your risk profile. Consequently, while you may make greater returns, you might also suffer greater losses.

"People don't want to make changes when things are going well," said Ed Slott, CPA and editor of Ed Slott's IRA Advisor newsletter. Many people with large IRA balances today got them by allowing the equity portion of their IRAs to grow unchecked, Slott speculates. "That's why you don't see a lot of rebalancing," he said.

Suppose you invested money in 1976 and initially allocated 60 percent of your portfolio to equity funds and 40 percent to bond funds. If you never rebalanced the account, today nearly 85 percent of your assets would be in equity funds and about 15 percent in bond funds because stocks posted higher returns over that time period. While your account would have posted strong returns, those profits would come at a higher risk level than you originally selected. And, more importantly, you would be subjecting your retirement money to potentially huge losses should equity funds take a dive.

Here's how it works: When you rebalance, you are automatically selling high and buying low. You are selling the funds that have done the best, while buying funds that aren't doing so well.

"What rebalancing forces you to do is to adhere to your investment strategy," Ticknor said.

Rebalancing How-to

Financial planners recommend you reallocate at least once a year and no more than four times a year. One easy way to do it is to pick the same day each year or each quarter, and make that your day to rebalance. By doing this, you will distance yourself from the emotions of the market, Wray said.

Many planners recommend you don't reallocate unless your portfolio is off balance by 5 percent or more.

You don't need to be a financial whiz to learn how to rebalance, you can do it with a pencil and paper.

If your account statement includes a pie chart showing how your money is invested, it's easy to figure out if you need to rebalance and how to do it. If you don't have a pie chart, you need to look at the balance of all your investments in the IRA. Calculate what percentage each represents of the total value, and then sell shares from the categories that are too large and buy shares in the categories that are too small until you are back in line with your original asset allocation percentages.

Should I Reallocate?

Reallocation is a different sort of readjustment; one in which you change the asset allocation percentages you originally selected in your account.

There are two general reallocation strategies: life-style reallocation and tactical or market-timing reallocation.

Older workers and retirees who are close to reaching their retirement goals and want to reduce their portfolio's risk often do life-style reallocation. Commonly, they reduce their holdings in equities and boost their holdings of bonds and cash as they get older so their portfolio won't have as much volatility.

"When you reach your 50s, you should have accumulated a substantial amount of money," said Wray. "People need to reassess at that point."

This type of reallocation should be accompanied by a careful reassessment of your goals, risk tolerance and your progress. In other words, you need to go through the entire planning process beginning at square one. "Folks need to rewrite their investment policy statement, saying 'here's what we are doing long term,'" said Leonard.

Read More How to accurately measure your fund's performance.

The second type, tactical reallocation, is the one that draws most financial planner's ire because it's based on market timing. This is when you decide to divert part of your portfolio to a particular asset class because it's hot.

In 1999, there was no hotter stock market sector than technology. The sector posted a 35.62 percent return last year, according to the Standard & Poor's 500 Technology Index. Many investors leapt into this sector, which posted a whopping 206.45 percent cumulative return over the last three years.

Suppose you created a retirement portfolio that promised a steady 9 percent return. It would be tough to stick with that plan, especially if all your friends were bragging about doing better with their tech stocks. Adding to the peer pressure is today's financial media, constantly touting winning funds, winning stocks and winning sectors.

Most of us want to be invested in the hot performer. We'd look at our portfolio and see which sectors have been doing poorly: bonds, for instance. So, we'd sell our bond funds and buy the tech stock fund. We would reallocate.

That would be the wrong thing to do, planners say. "Don't do tactical reallocation," said Greg Curry, certified financial advisor and president of Pillar Financial Advisors in Louisville, Ky. "You really have to be a psychic" to win.

One of the basic goals of asset allocation is to develop a diversified portfolio that will continue to make money no matter the economic conditions. Hence, you would have invested in dissimilar assets to create your portfolio. When you made your initial asset allocation, you assumed that when your investment in stock funds did well, your bond funds would likely do poorly. And, vice versa.

Related Reading The Value of Asset Allocation Your Guide to Understanding IRA Fees Stay in Your Protective Shell

"The minute you start deviating (from your original allocation) and start trying to make decisions on what you think the market will do in the short term, the probability of reaching the goal diminishes. You put yourself in the position of taking on a lot more risk," Wray said.

Ticknor offers some insight as to why people don't stick with their plan. "Most of the problem with individual investors is they act emotionally to events over which they have no control," he said.

He said that recent studies show that individuals who actively managed their accounts only earned half of the rate of return that the market generated. "It's that buying and selling that keeps them out of the market and degrades their return," Ticknor said. 

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.