Understanding Rebalancing in Retirement Accounts

Rebalancing is a crucial investment strategy used to maintain your desired asset allocation in a retirement account. As market conditions change, the proportion of different asset classes (like stocks, bonds, and cash) in your portfolio can shift, leading to increased risk or reduced returns. Regularly rebalancing your portfolio helps ensure that it aligns with your risk tolerance and long-term financial goals. Here are three diverse, practical examples of rebalancing in a retirement account.

Example 1: Targeting a 60/40 Allocation

In a typical retirement portfolio, an investor might aim for a 60% allocation in stocks and 40% in bonds. Over time, if the stock market performs exceptionally well, the stock allocation may rise to 70%.

To rebalance, the investor sells 10% of their stock holdings and buys bonds to return to the original 60/40 allocation. For example, if the initial investment was $100,000, with $60,000 in stocks and $40,000 in bonds, the new values may be $70,000 in stocks and $30,000 in bonds. Selling $10,000 worth of stocks and purchasing $10,000 in bonds restores the balance.

Notes:

• Consider rebalancing annually or semi-annually to minimize transaction costs.
• Be mindful of tax implications when selling assets in taxable retirement accounts.

Example 2: The Age-Based Strategy

As individuals approach retirement, they often adopt a more conservative investment strategy. For instance, a 40-year-old might maintain a 70/30 allocation (70% stocks, 30% bonds). As they turn 60, they might decide to shift to a 50/50 allocation to reduce risk.

This rebalancing could involve selling a portion of stock holdings and reallocating those funds into bonds. Suppose the portfolio is worth $200,000 with $140,000 in stocks and $60,000 in bonds. To adjust to a 50/50 allocation, the investor might sell $40,000 worth of stocks, leaving $100,000 in stocks and increasing bond holdings to $100,000.

Notes:

• This strategy aligns with the general rule of decreasing stock exposure as you age, known as the ‘glide path.’
• Regular rebalancing can help mitigate the impact of market volatility as retirement nears.

Example 3: Dynamic Rebalancing Based on Market Conditions

Some investors prefer a more active approach to rebalancing based on market conditions. For instance, if an investor notices that the stock market has declined significantly, they may choose to rebalance by purchasing more stocks at a lower price, taking advantage of the market dip.

Imagine the investor has a portfolio worth $150,000 with a target allocation of 60% stocks and 40% bonds. After a market downturn, their portfolio has shifted to 50% stocks and 50% bonds. To rebalance, the investor could sell $15,000 worth of bonds to increase their stock holdings back to 60% of the portfolio, now valued at $135,000 (60% of $135,000 is $81,000 in stocks).

Notes:

• This strategy requires careful monitoring of the market and may involve higher transaction costs.
• It’s essential to remain disciplined and avoid emotional decision-making during market fluctuations.