Rebalancing Your Mutual Fund Portfolio

A portfolio of mutual funds is no different from a portfolio of stocks, bonds, real estate, commodities, etc. when it comes to review and rebalancing. Average mutual fund investors tend to invest their money and then leave it alone for long periods of time, even years without adjusting their holdings.

What is Rebalancing?

When initially investing, investors should spread their money among a mixture of large and small company funds, various duration bond funds, commodity funds and real estate funds.  The average portfolio should look something like this:

  • 50% Stock mutual funds
    • 40% large company funds
    • 30% small company funds
    • 30% foreign stock funds
  • 30% Bond mutual funds
  • 10% Commodity mutual funds
  • 10% Real Estate mutual funds

Such a portfolio gives broad diversification among the major asset classes. The investor may select one broad mutual fund for each class, but most often will invest in several funds for each class for further diversification.

Once the decision is made to invest in these funds, most investors then track their performance each month or quarter. Some investors rarely look at the performance of the portfolio. Many investors are hesitant to make any changes once their initial portfolio has been selected. This could be due to fear of making the wrong choice, or not knowing when to make a switch.

If the initial funds were selected with care and mostly plain index funds, most of the time it is not necessary to change funds. But it is necessary to move some assets around so that the percent of assets in each fund match the overall investment objective. The original portfolio structure shown above is In Balance. But over time, some asset classes will outperform others. After a year or so, the investor may find that he has

  • 70% of assets in stock funds,
  • 10% in Bond funds,
  • 5% in commodity funds, and
  • 15% in Real Estate funds

This has occurred simply due to how each of the funds performed over the past year. So, now the investor has too much money in stocks and real estate, and not enough in bonds and commodities. This investor will simply call the fund company, or go online, and move funds from some funds to others so that the percentage of assets in each fund is back to the original structure or Balance. This is Rebalancing a portfolio.

How often to Re-Balance

Most investors will find that they only have to rebalance their portfolio every 6 – 12 months. Theoretically, a portfolio could be rebalanced every day, but this is going overboard. The intent is to maintain roughly the original percentage of assets in each fund. If one fund has 1% more or less, this is no reason to lose sleep over it. Also, rebalancing too often may encourage the investor to emotionally move money out of certain funds based on recent news events. Moving money around funds based on news of the day can cause havoc with a long term investing approach and is rarely a winning strategy.

The rebalancing event is also the time to decide if a change in fund is needed. If one fund is not performing as expected, then select a new fund and move the money. This may happen because the fund was too focused on one investment sector or the fund had a change in investment manager. There is nothing wrong with changing funds, especially if the investor has become uncomfortable with the holding the fund.

Rebalance Without Emotion

When an investor rebalances his portfolio, he is not making new investment decisions. Rebalancing is a mechanical action to simply have the correct proportion of assets in each investment class.

Investing for the long term means sticking with the strategy, even while the markets are falling. Many investors make the big mistake of withdrawing funds when the markets are down. This is the exact time they should be investing more money. For example, many investors lost 40% 60% of their assets in the 2008 recession. Unfortunately, many of them withdrew their assets and invested in money markets. Then in 2009, 2010 and 2011, the markets gained 40% – 60%. Had the investors stuck with their long term strategy, their assets would have grown back to their former levels. Sticking with a long term strategy is difficult emotionally, which is why investing requires discipline.

When the investor rebalances, he is not changing investment strategy. He is merely moving money back to their original proportions. This should be done without emotion and without deciding on the strategy itself. Changing strategy should be a separate event and done with much planning.