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Re-balancing is an important part of the investment and financial planning process for a number of reasons. First, broker neglect is less common since it ensures holdings reviewed periodically. Second, it initiates a conversation with the investor that may trigger other considerations. Third, it instills discipline; the advisor is forced to sell high and buy low, at least on a comparative basis. Fourth, at times there will be losses when a position is sold; such losses can be used to offset gains plus up to $3,000 of ordinary income each year. Fifth, and perhaps most important, it repositions the portfolio so its risk level is the same as the client's.
A number of studies have shown what happens to an equity/fixed-income portfolio left unchecked. The results of these studies are obvious. Over time, the equity portion represents a bigger and bigger percentage of the portfolio.
- Avoid re-balancing too often unless the markets dictate otherwise: Studies have shown there is a slight advantage in performance by re=balancing once every 12-18 months.
- Focus on the stock/bond mix: Changes in value, growth, small, mid or large cap equity categories are fine, but the biggest impact on risk and return will be the simple equity/fixed income mix.
- More leeway with secondary categories: By employing additional categories (sectors) one can avoid a re-balance as a specific category or sector, due to a negative correlated portfolio, may offset the stock/fixed income mix
- Use tax advantaged accounts: Utilizing retirement accounts (IRA's) or tax deferred annuities provide hedges against a possible tax loss within the portfolio since buying and selling within an IRA creates no taxable event
Source: Institute of Business and Finance: Graduate Series Module V.