Even though asset allocation will determine over 90% of your returns, it’s important to periodically rebalance your retirement accounts. I’ve shown why rebalancing will reduce your risk in the first part of this series and also how often you should rebalance. Once you’ve selected your AA, it’s better to touch your accounts too little rather than too frequently. There can be a lot of fees associated with rebalancing, and although you can minimize them by doing it yourself, you need to have a grasp on the overall picture of your accounts.
Now that you know why and how often to rebalance, actually doing it is the easy part. I take a look at all my retirement accounts as one big(hopefully one day, giant) basket that includes 401k, IRA and any after-tax accounts. If you’re investing in after-tax retirement accounts, you need to take into account the principles of tax efficient fund placement. But if you start investing in your 401k/IRA early, you shouldn’t need after tax accounts(your after tax money can be spent best in real estate, where you’ll pay no taxes on capital gains and you only have to put up 20-30% of the investment).
Assess All Your Accounts
I like to keep all of my accounts as simple as possible, keeping only three funds in my accounts at all times: Total Stock Market Index Fund, Total International Stock Index Fund and Total Bond Market. Equities-wise, this allows me to invest in small, medium and large cap US companies and also gives me exposure to developed and emerging markets internationally. Bonds-wise, this gives me exposure to corporate bonds and government bonds of all maturities(short, mid and long)
I think it’s simplest to hold your AA across all of your accounts. Here’s an example of what I mean:
Jason has a 90/10 Stocks/Bonds allocation. He has $5k in his 401k and $5k in his Roth IRA. For Jason’s Roth IRA I would recommend he hold $5k in stocks and in his 401k, he should hold $4k in stocks and $1k in bond(as opposed to $4,500 stocks and $500 bonds in each of his accounts). This will give him his desired 90/10 AA across his entire accounts and allow him to hold the fewest number of funds.
Match Your Target Allocation
For investors with multiple accounts(401k, IRA, etc), rebalancing is a little more difficult, but the process remains the same. No matter how many accounts you have, start by adding up the entire value of all your accounts. Next, multiply the total value by your stocks/bonds AA. Do the same for your domestic/international allocation and you’ll be left with four dollar amount numbers. These are the numbers you want to match through a combination of funds in your accounts. Here’s another example:
Damon has a 401k with $25k and a Roth IRA with $10k. His desired AA is 70/30 with a 50/50 domestic/international split. The total value of his accounts is $35k so we can figure out what his target allocation numbers should be using the method described above:
|Roth IRA Value||$10,000|
Add Funds to Match Your Target
Once you’ve calculated your target amounts, you need to decide what money goes where. In the example above, I would fill up the Roth IRA with $10,000 of domestic stocks and put $2,250 domestic stock, $12,250 international stock and $10,500 bonds in the 401k. This would allow Damon to invest in just four different funds(3 of which are unique) and encompass the entire market.
I think rebalancing is pretty easy, but it’s the work leading up to it which is the hard part. I use a simple spreadsheet that I obtained from the boglehead’s forum to track my asset allocation and aid with periodic rebalancing. Once you’ve done it a couple times, it gets easier and easier. There are a lot of things to worry about with rebalancing, but actually employing your strategy should be relatively easy.
Readers, what methods do you use to rebalance? Do you have a spreadsheet you’d like to share?
-Harry @ PF Pro