With either approach, the Securities and Exchange Commission's "Beginners' Guide to Asset Allocation," says there are three different methods of buying and selling securities as you rebalance your portfolio:
%%DynaPub-Enhancement class="enhancement contentType-HTML Content fragmentId-1 payloadId-61603 alignment-right size-small"%%1. You can sell off investments from over-weighted asset categories and use the proceeds to purchase investments for under-weighted asset categories.
2. You can purchase new investments for under-weighted asset categories.
3. If you are making continuous contributions to the portfolio, you can alter your contributions so that more investments go to under-weighted asset categories until your portfolio is back into balance.
Christine Benz, director of personal finance for Morningstar (MORN), favors a "more hands-off long-term strategic approach" to rebalancing. From her perspective, investors often make poor decisions when experimenting with the tactical approach.
"A great case in point is that bond mutual funds have been getting a lot of money in 2009, and arguably, investors were looking in the rearview mirror and responding to what they experienced in 2008 – the terrible market rout," said Benz.
Placing more money into bonds this year may not have been the best decision for every investor, given the stock market's strong rebound. Looking toward next year, Benz suggests investors pay attention to style diversification as well as the different asset classes they invest in. Strategically rebalancing a portfolio to include the right amount of small cap value or large growth stocks based on age and retirement goals may yield better results than abandoning stocks to avoid losses at any given time.
The bottom line for Benz is that once the client and advisor have determined the correct asset allocation with targets in place, rebalancing should be about figuring out how to get back to those targets. "That formula should stay pretty consistent and it shouldn't vary depending on the market environment," she said.
From the tactical point of view, investors who were clobbered because they held to a buy-and-hold strategy as the market crashed may want to rebalance in a more proactive manner. However, to do this, the client and advisor must agree on a life-appropriate asset allocation and the true level of risk the client is willing to endure. Being tactical relies on forward-looking projections of economic conditions which may affect the markets, stocks, bonds, commodities and interest rates.
Philip Spoljarick, a financial consultant for Charles Schwab suggests that such investors create a truly diversified portfolio of non-correlated assets. "Make sure you have different assets classes that don't act the same way," he advises, adding that the portfolio should include a sizeable portion of cash to make tactical purchases based on changing market information. Spoljarick said a typical 60% stocks/ 40% bonds portfolio could stand to have 5% allocated to cash.
"Part of being tactical or strategic is making sure you have enough cash to ride out the ups and downs of the market so that you don't have to be a forced seller of your assets when the market drops," says Spoljarick. If there is a repeat to the market meltdown of 2008, having cash will allow investors to rebalance by buying assets that are on the way up, without having to sell off stocks at market lows.
For investors with 401(k)s, Spoljarick suggests they become disciplined profit takers during the rebalancing process. Because stocks performed well in 2009, chances are certain funds in many investors' 401(k)s have had a significant percentage increase, placing a larger percentage of the overall portfolio at heightened risk.
"If things are flat next year or if we have a down market, certainly if you peel some money out of equities in your 401(k) plan and put it in more stable assets, that might be to your benefit," he said.
Tactical investors may also want to consider rebalancing with a new approach developed by Hepburn Capital Management's CEO William Hepburn, who is advocating investors rebalance their portfolios each quarter using the average stock/bond allocation of members of the National Association of Active Investment Managers (NAAIM). Called "Adaptive Rebalancing," Hepburn contends that NAAIM members, who consist of hedge fund, mutual fund and separate account managers, produce investment returns that outpace the traditional 60/40 mix of stocks and bonds many investors use when rebalancing.