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Tuesday, January 27, 2009

Why Rebalancing is Especially Important this Year

That $355 billion in spending isn't about the economy.

One of the hoariest clichés of investing is "Buy and Hold." As we've all learned in the recent past, that sentiment seems less than effective. Instead, investors should really approach their portfolios with a mindset of "Buy and Beware," even when it comes to their retirement portfolio.

While it is never smart to trade in and out of shares or attempt to time the stock market's highs and lows, there is wisdom in tracking the balance of your investments over time. It is a good discipline to analyze the makeup of your holdings at the start of each year and make sure the components of your portfolio match your strategy.

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The reason to examine the balance of your portfolio at the start of a year is that performance data for the previous year are readily available. You could do this kind of thing anytime during the year, but it is best to do it once a year.

Locking In Gains

Rebalancing your portfolio makes sense for several reasons. For one, it prevents you from chasing performance. Usually, you will sell the strongest performers and add to laggards in an effort to restore balance to your portfolio.

Toward the end of the technology and telecommunications bubble of the late 1990s, those who ignored their portfolios would have found themselves severely overweight in these sectors. Rebalancing would have meant selling technology and telecommunications shares or mutual funds and acquiring weaker-performing funds, such as commodity funds, to replace them. That would have locked in gains and protected you to some degree from the sharp downdraft in technology and telecommunications shares as the bubble burst.

Especially Important

Second, rebalancing ensures that you won't find your investment mix too heavily weighted toward stocks, bonds or cash. After the runup of stocks from 2003 to 2007, investors who hadn't rebalanced annually would have found the stock component of their portfolio overly high. A rebalancing discipline again would have locked in some gains and protected you a bit as stocks headed south in 2008.

This year, the act of rebalancing is especially important. Many people simply don't want to look at their portfolios, fearing the bad news. But as with visiting the dentist or doctor, it is imperative that you visit your money and maintain a disciplined approach to investing, especially in difficult times. Throwing up your hands is not a good strategy.

In 2008, a lot of sectors performed terribly, and the stock market proved a particularly nasty investment realm. The Dow Jones Industrial Average fell 34%, and the Russell 2000 index of small-cap stocks dropped 35%. The vast majority of mutual-fund strategies recorded losses.

But lost in the grim headlines, other investment assets performed well. The Long-Term Treasury Index, as measured by Barclays Capital Indexes, gained 24%. Intermediate-Term Treasurys gained 11%. Even highly rated corporate bonds edged ahead 2.7%. Cash measures also rose. Money-market funds added 0.7%, and one-year certificates of deposits gained 2.4%.

Selling Bonds

In other areas, gold bumped ahead 4.3% and high-grade collectible coins rose 8.8%.

What does all this mean? If your investment strategy is to hold 65% in stocks, 25% in bonds and 10% in cash, then during the past year your bond and cash holdings have grown to be much larger parts of your portfolio, while your stock portion has shrunk.

This leads to an uncomfortable issue: In order to rebalance back to a 65-25-10 mix, you would need to sell bonds and use those proceeds to add to your stock holdings. In normal times, this wouldn't seem so hard. But these aren't normal times. Indeed, it might be wise to modestly tweak the cash portion of your investment strategy a bit higher in order to give you more peace of mind in these challenging times.

Still, there's wisdom in rebalancing. Long-term government bonds have rallied sharply during the past year, making another such rally unlikely. With the government expected to spend hundreds of billions on stimulus, inflation could become an issue, which would erode the value of bonds.

Inexpensive Stocks

And stocks, by many measures, look inexpensive, especially for a longer-term investor. We've already suffered through one of the worst bear markets in the past century, meaning that the probability of even steeper declines is lessened.

Therefore, a prudent rebalancing would mean shedding some of your bond gains and using that money to add to your stock positions. Since forecasting which part of the market will rebound best is tricky -- only two of the Dow Jones 100 industry groups had an up year in 2008 -- investing in a low-cost, broad index fund makes the most sense.

Don't forget that an element of investing is risk. Clinging to past gains makes it more likely that you will lose some of those gains, as was the case after the tech boom and after the recent stock-market gains of 2003 through much of 2007. While it seems scary, rebalancing toward stocks and away from bonds, while adding a bit to your cash position in the interest of psychic comfort, makes sense, at least if history is any guide.

Write to Dave Kansas at