Rebalancing Strategy to Avoid ‘Risk Creep’

Mutual fund rebalancing strategies won’t prevent those white-knuckle down days in the stock market, but they might make such declines easier to live with.

Rebalancing strategies pursue the simple goal of keeping your portfolio finely tuned to a target mix of assets. To do that, they direct you to sell off some shares in your high-flying funds and reinvest the proceeds in laggards. Sometimes this means juggling money from bonds to stocks or vice versa.

Sound familiar?

Rebalancing features a buy-low, sell-high bias similar to that of dollar-cost averaging, the strategy of investing a fixed amount of money on a regular basis. (In dollar-cost averaging, you are automatically buying less when stocks are high; when they are low, you end up buying more. But you don’t have to know which is which.)

“Rebalancing gives you a better bang for the buck, since you’re taking cash away from your winners and adding it to your losers,” said Stephen Scott, chief investment officer for the Sierra Asset Management account run by the Sierra Trust Funds in Northridge.

Rebalancing isn’t a market-timing strategy built around guesswork or hunches but an ongoing approach whereby you try to maintain a risk/return profile with which you’re comfortable. Also unlike market timing, rebalancing is based on making small refinements to your portfolio, not drastic shifts.

The approach can add 0.5% to 1% annually to your returns over a 20-year period compared to what you’d get with a straight buy-and-hold strategy, said Dennis Miller, an investment advisor at Miller/Russell Co. in Phoenix.

Without rebalancing, a typical mix of mutual funds will tend to get riskier over time because the stock funds in the portfolio will grow more than the bond or money-market funds--a phenomenon known as “risk creep.”

A rebalancing approach can help you feel more comfortable about staying in the stock market long term, since you’re periodically taking profits from hot funds and channeling the cash back into cold funds. With an automatic rebalancing mechanism in place, you don’t have to agonize about what to do when the market drops 100 points in a day.

Robert Radus, a certified public accountant in Irvine, has invested some of his retirement money in a portfolio of mutual funds in the Sierra Asset Management program.

“I’m a CPA working 12 to 13 hours a day, and I literally don’t have time to play the stock market,” Radus said. “What I like about this program is that I don’t have to think about it.”

Sierra’s program, which is marketed through brokerages, doesn’t offer a pure rebalancing approach, since the company’s investment strategists can reallocate cash among funds based on their view on the financial markets, without having to return the mix to a predetermined target. Yet the program has a similar buy-low, sell-high bent, and the reallocation shifts are gradual ones, Scott said.

A new program from T. Rowe Price Associates of Baltimore offers a more representative example of a rebalancing strategy. The company will shift money back to each investor’s target asset mix on a quarterly basis, automatically and free of charge. The program is open only to investors with $25,000 or more in T. Rowe Price mutual funds held within individual retirement accounts.

The IRA feature is important because in a regular taxable account, frequent buying and selling of shares would trigger capital gains and losses.

Rebalancing plans also are appropriate in variable annuities, which like IRAs offer tax-deferred growth until cash is withdrawn, presumably in retirement.

“Rebalancing makes sense inside of variable annuities because you’re not taxed on making those transactions,” said Jennifer Strickland, editor of Morningstar Variable Annuities/Life, a publication from Morningstar Inc. of Chicago.

If transaction costs are a major consideration for you, you might find it more cost-effective to rebalance by channeling new investment dollars into laggard fund categories, rather than switching cash among funds, Miller says.

For a rebalancing plan to work well, it’s important that you select a suitable mix of assets--based on your risk tolerance, time horizon and other considerations--and that you choose appropriate mutual funds.

Rebalancing “doesn’t excuse you from the need to pick the right mutual funds to meet your asset-allocation goals,” Strickland said.