Portfolio Rebalancing

The idea behind portfolio rebalancing is simple: You sell a portion of your investments that have done well and buy more of those that have failed to keep pace. By shifting assets from one class to another, you restore your original asset allocation--the mix of investments that is best for your goals, risk tolerance and time horizon.

Many people tend to shy away from rebalancing because it feels counterintuitive. It means selling some of your winners--those that have done the best--and buying more of your losers. But it actually is essential for keeping your portfolio in sync with what you want to achieve. And recent academic studies show that annual portfolio rebalancing will add up to one percent or more in returns over a market cycle of five to seven years. It also has been shown to lower overall risk.

The following guide will get you started on this all-important investment management technique.

Guide to Rebalancing Your Portfolio

Set guidelines

Choose a margin of deviation for your portfolio that you can live with. For example, I aim to keep one-third of my own portfolio in large cap stocks, one-third small cap stocks and one-third international stocks. Whenever any one portion climbs above 40 percent, I know it's time to rebalance.

Never act on impulse

Part of the benefit of being a long-term investor is not having to watch the markets every day. To avoid over-reacting to short-term market movements, commit to looking at your balance once a year, preferably in January. If each asset class of your portfolio is within your margin of deviation, leave it. If one class deviates too much, however, go ahead and rebalance.

Consider adding money

Many people sell part of their over-performing investments in order to free up cash to buy more of the underperforming investments. There's another way, although it involves more active involvement with your trading. You can re-direct new cash purchases towards the asset that's underperforming, both buying on the cheap and re-balancing your portfolio. Then, put any automatic investment plan back on auto-pilot once you're back on track. The best advantage of this? When you avoid selling, you also avoid paying capital gains tax.

Adjust your allocation as needed

You initially set your asset allocation because you had certain goals that you wanted to reach in a certain amount of time. As your financial goals change along with your time-horizon, re-consider your allocation and your portfolio's overall risk exposure as part of your regular rebalancing.

THE BOTTOM LINE

A smart portfolio is made up of investments that don't all move the same way at the same time. But sometimes this will lead to a portfolio that's gotten too far away from your original blue-print. By occasionally rebalancing your portfolio, you'll ensure that you stick to your original plans and have the kind of discipline that leads to long-term success.