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Investing Specialists

The Error-Proof Portfolio: 6 Rebalancing Mistakes to Avoid

Lightening up on stocks? See if you can't achieve other goals at the same time.

Rebalancing a portfolio is difficult to swallow under the best of circumstances. Trimming what has performed well and adding to what has not runs counter to most investors' natural instincts. Moreover, the unloved asset class that you recently boosted rarely rebounds straightaway.

It has been particularly easy to ignore experts' admonitions to rebalance over the past few years. Even though many investors' equity allocations blew past their target weightings a few years ago, and stock valuations haven't looked cheap for a while, a policy of benign neglect has been not just psychologically comfortable, it has also been the winning portfolio strategy.

For example, a portfolio that was 50% stocks and 50% bonds coming into 2009 would have been nearly 60% stocks by the end of 2012. If the target allocation were 50/50, many experts would have recommended trimming at that point; after all, the portfolio's asset allocation had veered by nearly 10 percentage points from its target. But rebalancing at that point would have hindered, not helped, the portfolio's subsequent performance. Stocks went on to enjoy tremendous gains in 2013--so great that the portfolio that was 50% stock/50% bond at the beginning of 2009 would have been roughly two-thirds equity as of August 4, 2014.

Yet the main benefit of rebalancing has always been risk reduction, not return enhancement. And the recent market volatility may finally be lighting a fire under some investors to revisit their asset allocations and possibly rebalance their portfolios.

If you've decided it's time to check up on your stock/bond mix and potentially embark upon rebalancing, be sure to avoid the following pitfalls.

Mistake 1: Not starting with your company retirement plan assets
Perhaps you can bring your portfolio's allocations back in line with your targets by adding new money (external to the portfolio) to the unloved asset class. But for many people, getting their portfolios' asset allocations back in line will require selling something, and that can mean racking up tax and/or transaction costs that can water down any benefits you achieve by rebalancing. You can avoid those trading-related costs by concentrating your rebalancing activities within your tax-sheltered accounts, especially your company retirement plan. Not only will you not incur any capital gains taxes as you make changes to these accounts (you only pay taxes when you pull your money out), but 401(k), 403(b), and 457 plans are usually free of loads and other transaction costs, too. Making changes within your IRA is similarly sensible from the standpoint of limiting capital gains taxes, though your trades may incur transaction costs. Selling appreciated holdings from a taxable account should be a last resort, unless you have losers to offset them or expect to be in a particularly low tax bracket in 2014.

Mistake 2: Failing to pick your spots
Correcting any imbalances with your baseline asset allocation is job number one of rebalancing. After all, your portfolio's allocation to stocks, bonds, and cash will tend to be one of the biggest determinants of its risk/reward profile over time. (See our Investment Pyramid for a hierarchy.) But rather than taking an equal percentage out of each of your equity holdings and adding proportionately to each of your bond positions, it pays to be surgical when deciding where to subtract and where to add. Morningstar's  X-Ray functionality can help you see where you have the biggest overweightings on a sector and Morningstar Style Box basis. Equities across the board are up substantially over the past five years, but small- and mid-caps have outperformed large, and U.S. names have outperformed foreign. On the bond side, lower-quality and long-duration bonds have posted dramatically higher returns than shorter-duration gilt-edged bonds.

Mistake 3: Not addressing other problem areas
In a related vein, you can use rebalancing to take care of other problem spots that are lurking within your portfolio. Are you carrying around a big position in the stock of your employer (which happens to be a bank)? If you also need to correct your portfolio's tilt toward equities and a sizable overweighting in the financials sector, you can kill three birds with one stone by pruning the bank stock. Or perhaps you own individual companies--some of which have overshot their fair values by a wide margin--or you've been concerned about the succession plan at one of your most heavily weighted equity funds. Concentrate your trimming on parts of your portfolio that were bugging you anyway.

Mistake 4: Settling for faux-diversification 
If you need to lighten up on equities--and that's the case with most rebalancers these days--make sure you're not steering the proceeds to bond types with equitylike characteristics. That includes high-yield bonds, bank-loans, some nontraditional bond funds, and emerging-markets bonds. These categories may beckon because they can be less sensitive to interest-rate changes than high-quality bonds; some of these bond types, such as high yield, have also been on a tear recently. But they also tend to be more sympathetic to the economic cycle and, in turn, the equity market than is the case with high-quality bonds. Remember, the goal of portfolio rebalancing is to take risk off the table, and the best way to do that is to make sure your holdings aren't all moving in lockstep. High-quality bonds, including deeply unlovable Treasury bonds, will tend to offer the best diversification for a portfolio that's anchored in stocks. This article discusses the topic in more detail.

Mistake 5: Not tying in rebalancing with other planned distributions
If you're retired and actively taking withdrawals from your portfolio--to meet your living expenses and/or to satisfy required minimum distributions from your IRA or company retirement plan--it's valuable to coordinate rebalancing with those withdrawals. That way you can reduce your portfolio's risk level while also freeing up cash. Indeed, I've argued that following the multiyear runup in stocks, retirees in search of income would do well to prune their equity holdings rather than chasing yields that have slunk lower and lower.

Mistake 6: Not moving slowly if your portfolio is dramatically out of balance
Are you dramatically underweight bonds relative to your targets? If so, step back and think through your strategy for putting money to work, because bonds aren't risk-free, either. Younger people who are still in accumulation mode might consider dollar-cost averaging into bonds over a period of several months, as Adam Zoll discussed in this article. Investors who are closing in on retirement, meanwhile, should consider de-risking immediately, moving the assets they have earmarked for bonds into cash and then slowly deploying that money into bonds over a number of months, thereby experiencing a variety of price points for their bond purchases. This article discusses the strategy in more detail.

See More Articles by Christine Benz