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Asset Allocation: Part 5 of 5

By Colleen Mulder-Seward, MBA

This article is the last in a series about asset allocation. In the last article of this series, you determined your ideal asset mix. In this article you will learn when and how to rebalance your portfolio.

In addition to evaluating your ideal mix after each life event or every five years, you should also rebalance your portfolio annually.  Rebalancing your portfolio simply means returning each asset category to the percentage you initially set.  If you have set up your initial allocation properly, no drastic revisions to your portfolio should be needed. 

You will need to rebalance your portfolio whenever the weight of any asset category deviates from the original by more than 5%.  The graphs below are sample asset allocations. The graph on the left shows an ideal mix at the beginning of 2005 and on the right is a potential year-end mix. 

Charts

The following formula should be used to determine a 5% deviation from a percentage.
 
Formula:

Ideal percentage (as a decimal) x .05 = 5% deviation
Then,
Add the 5% deviation amount to the ideal percentage for the top range and subtract the 5% deviation from the ideal percentage for the bottom range.

Example:
Ideal mix is 20%

.20 x .05 = .01 or 1%

.20 + .01 = .21 or 21% for the high range and
.20 - .01 = .19 or 19% for the low range

Because some of the categories deviate from our established ideal mix by more than 5%, some rebalancing is needed to bring the portfolio back in line with the established ideal mix.  Therefore, based on the ideal mix graph shown above, the table below shows those categories that need rebalancing.  These include selling some of your small cap stocks and adding to your bonds and large cap stock positions.  Also, the cash should be used to add to the international stock category. 

 

Ideal Mix

5% Deviation

Large Company Stock

20%

<19% or > 21%

Medium Company Stock

24%

<22.8% or > 25.2%

Small Company Stock

20%

<19% or > 21%

International Company Stock

16%

<15.2% or > 16.8%

Bonds

20%

<19% or > 21%

Cash

0%

Any deviation

The benefits of rebalancing your portfolio annually are that it forces you to take profits out of asset categories whose prices have increased and reinvest that money in assets that have the potential to be more profitable.   Rebalancing also saves you from taking on too much risk.  Historically, bonds and stocks have moved opposite of each other.  Thus, by rebalancing your portfolio you will avoid one asset class from becoming dominant in your portfolio.  The people, who survived the technology bubble of 2000, used rebalancing when the technology stocks started to overtake their portfolio.  Their portfolios are better for it.

My goal for this series of articles was to have you understand asset allocation thoroughly, in easy to understand terms.  I hope you have learned something new about asset allocation and how to apply it to your individual needs. 

In our next newsletter, we will explore starting your own business after retirement.

Retirement Intelligence Information Services™ is published bi-monthly by Retirement Calculator, Inc. (Companies and mutual funds mentioned in Retirement Intelligence Information Services™ are used as illustrations or suggestions for study and are presented for educational purposes only. They are not to be considered as endorsed or recommended for purchase by Retirement Calculator, Inc.) Investors should conduct their own review and analysis of any company of interest before making an investment decision. Investors should further consult their accountant, tax expert and/or financial advisor before making any investment decisions. Neither Retirement Calculator, Inc. nor its content providers are responsible for any damages or losses arising from any use of this information.
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