Boost Your 401k Returns by Rebalancing

By Clifton Linton
Senior Writer, mPower

If you're like most Americans, you probably haven't bought or sold any of the funds in your 401k plan since the day you set it up. If this is the case, you're probably cheating yourself out of better returns in your portfolio.

What many workers don't realize is that they need to regularly rebalance their 401k portfolio to stay within their risk level and to protect against potentially huge losses.

There's an old saying that goes "do anything long enough and it becomes a habit."

Billie Moore wants to pick up the habit of rebalancing her 401k account. For the past seven years, her money lingered untouched in her account. Then, when a departing co-worker revealed her 401k balance, Moore, 52, took a look at her own account and found it suffered from two problems: an uninformed initial allocation and lack of regular rebalancing.

Part of her problem stemmed from a lack of education. "I never knew I could have gone in and (re)allocated," she said. If she had done this, she would have noticed her initial error, quickly corrected it and got her portfolio on the right track years ago.

Moore's case, unfortunately, is common among American workers. They make an initial allocation, sometimes mistakenly, and then ignore the account, save checking to see that the balance is rising.

"Eighty percent of people don't rebalance," said David Wray, president of the Profit Sharing/401k Council of America. "We feel strongly that one of the education propositions we need to get to people is that they need to rebalance."

"Rebalancing quarterly can add as much as another half percent of return a year," said Joel Ticknor, certified financial planner and president of Ticknor Financial Inc. in Reston, Va.

"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 rebalancing with reallocation. They are two totally different concepts. Many financial planners disapprove of frequent 401k asset 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 funds in your plan so that your asset allocation percentages remain consistent.

The Initial Allocation

Hopefully, before you began contributing to a 401k, 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 in your 401k plan 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.

"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.

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.

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

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.

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

Rebalancing How-to

Financial planners recommend you rebalance 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.

Moore said she might rebalance quarterly. "These allocations I have … have given me a starting point so I can look at percentage of return," she said. "I'll get my first statement in October. That won't be enough time. I'll look closely in January."

Further, many planners recommend you don't rebalance 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. Suppose you initially allocated 40 percent of your portfolio to bond funds and 60 percent to equity funds. Further suppose that when you get your next statement, it shows that 70 percent of your assets are in equity funds and 30 percent are in bond funds. To stay within your acceptable risk level, you should sell enough equity funds to bring that back to 60 percent of your assets and buy enough bond funds to bring them up to 40 percent of assets.

If you don't have a pie chart, you need to look at the balance of all your investments in the 401k plan. 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 plan.

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.

Hopefully "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 Scott Leonard.

Billie Moore reallocated her 401k plan in August because she never selected the correct funds in the first place, being 100 percent invested in money-market mutual funds.

The friend that told her about rebalancing also helped her figure out how to reallocate her funds. Moore took her 401k money and split it so that 10 percent of her assets are in money-market funds, 30 percent in bond funds and 60 percent in equity funds.

The second type, tactical reallocation, is the one that draws most financial planners' 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. As measured by the Standard & Poor's 500 Technology Index, the sector posted a 35.62 percent return.

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

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.

"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.