Set A Course For Higher Returns

Letting your portfolio drift too far off target can cost you

A diversified asset allocation plan can help you ride out the market's ups and downs without too much anxiety. But even the most smartly conceived portfolio needs to be adjusted now and then to keep it from drifting off course. That means rebalancing -- or trimming your winners and bulking up on your losers until your portfolio once again conforms to your plan. Yearend is a good time to do it, especially if you'll be making changes in a taxable account.

Yes, selling winners and buying losers is counterintuitive. But disciplined rebalancers are likely to earn higher returns than those who let their portfolios get out of whack. One reason: Rebalancing helps ensure you won't become overexposed to asset bubbles or have too little in laggards to make a difference when a rebound arrives. By preventing a portfolio from going to extremes, this exercise also smooths returns, which allows them to compound more steadily. "You can make a very material difference in your savings over time by rebalancing and getting your asset allocation right," says Marc O. Mayer, chairman of AllianceBernstein Investment Research & Management Inc.

For simplicity's sake, there's a lot to be said for making your moves by the calendar -- say, once a year. But if you want to eke out the most you possibly can, rebalance the way many institutions do -- whenever a position deviates significantly from your allocation plan. Of course, how you trade matters, too: To minimize commissions and tax bills, do as many transactions as possible inside individual retirement accounts (IRAs) and 401(k)s. Better still, rather than selling taxable winners, try to get your portfolio back in line by funneling new contributions into underrepresented assets.


To rebalance the institutional way, you've got to decide how much to allow your positions to shift. For most investors, Alliance calculates, it's a good idea to take action when the percentage of your assets in bonds strays by about three percentage points from your target. For example, if your plan calls for having 30% in bonds, you'll need to start buying when your allocation dips to 27% and selling when it rises to 33%. For equities, which are more volatile, the trigger point is five percentage points. That's where the expected benefits of keeping your portfolio on plan outweigh the costs of reshuffling.

These ranges are not set in stone. Indeed, someone with a high risk tolerance can let the holdings drift more -- say, up to 10 percentage points -- thereby saving on transaction costs, says David Rosenberg, head of U.S. investment solutions at Citibank's (C ) private bank, which also uses ranges. Likewise, to avoid realizing short-term capital gains, an investor in the highest marginal tax bracket should use slightly higher triggers. If you're trading in an IRA or 401(k), you can act a little sooner -- when your bonds stray by two percentage points and stocks by four.

Consider a fairly standard portfolio with 30% in U.S. bonds, 25% in U.S. growth stocks, 25% in U.S. value stocks, and 20% in international stocks. An Alliance study shows that between 1997 and the end of 2002, rebalancing using trigger points would have yielded 0.6% more a year than if the portfolio was never adjusted. (In part to reduce the tab for commissions and tax bills, Alliance rebalances only halfway to target allocations. That means if you want 50% in equities but have 55%, you would trim to 52.5%.) By using an annual approach, you would still outperform, but by about half as much. The estimated gains may be a bit lower now since the markets are less volatile than when Alliance did its study.

Regardless of how you rebalance, do it in cost-effective ways. For example, to reduce taxes, harvest losses to offset your capital gains, says Jack Caffrey, equity strategist at JPMorgan Private Bank (JPM ). (Of course, replace what you sell with similar investments.) Remember that how you rebalance is just as important as when.

By Anne Tergesen

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