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Rebalancing is the act of selling shares of an investment in your portfolio that has done particularly well, and using those funds to buy shares of another investment that has not, in order to maintain your original portfolio allocation. When you create a 401(k) investment portfolio, you should consider both your risk tolerance, how much time you have until retirement, as well as the allocation of other investments you have earmarked for retirement.


Why should you rebalance your portfolio?

The purpose of rebalancing is to maintain the desired risk-reward ratio in your earmarked portfolio for your goal. For example, when you set up a Guideline 401(k) account, you take a suitability questionnaire that recommends a 401(k) portfolio allocation for you, based on how much risk you can handle as an investor. That portfolio allocation is chosen for the long term goal of retirement, and the recommendation factors in both investor and market variables.

Investor vs. market variables

Your portfolio allocation should not change over time, unless one of your investor variables changes. Investor variables have to do with your own personal situation as an investor. This could include a change in your time horizon, or a personal life event such as marriage or the birth of children, that could prompt you to take less risks. In contrast, market variables are inevitable changes to the market or economy, such as a recession or huge market boom. Market variables should already be factored into your target portfolio allocation when you choose it based on historical performance of markets.

Let’s take an example of a Guideline participant who has a moderate risk tolerance and has chosen a portfolio with 65% stocks and 35% bonds. If the participant just set their initial allocation and then let the portfolio sit, over time, their allocation would be very different from the original target. If the market is bullish, stocks will rise, and if the market is bearish, stocks will fall. As a general rule of thumb, stocks will perform better than bonds in the long-term, so in a few years of a normal market cycle, without rebalancing, you may see that the portfolio allocation has changed so that it is now 75% stocks and 25% bonds, and no longer in line with the participant’s moderate-risk investment strategy.

Your target allocation should be reassessed at least every few years. Guideline recommends you assess your portfolio suitability every year, as our portfolio recommendation can change with your age and other situational incidents.

Rebalancing in action

So how can you fix the above problem? You can rebalance! To rebalance the sample portfolio above to the original desired allocation, the participant would need to sell 10% of their stock holdings and purchase the same amount in bond holdings. This maintains the desired allocation so that they are not over or underweight in either asset class.

How Guideline rebalances

There are three ways Guideline keeps your desired portfolio allocation on target.

  1. If you’re an active participant in your 401(k) plan, you will typically be making regular deferrals into your 401(k) account. Guideline automatically invests these funds in a way that keeps your asset allocation on target.

  2. If your portfolio “drifts” more than 5% from its target allocation, Guideline will automatically rebalance your portfolio. Drift is defined as “the sum of the absolute drift of each holding, divided by 2.”

DriftEquation-4
Since 10% is more than 5%, Guideline will automatically sell 10% of the stock holdings and buy 10% more in the bond holdings to rebalance the portfolio.

  1. Finally, Guideline does a daily valuation of target allocations. Any residual holdings that have not triggered a rebalance because the portfolio did not reach a 5% drift will be sold, and those funds will buy shares in the target allocation. For example, let’s say a participant changes their portfolio to remove Fund A and replace it with Fund B. However, Fund A pays a dividend to the portfolio after it is sold. Though the dividend in Fund A did not trigger a drift rebalance, Guideline will still sell all of Fund A and move that money into the appropriate investments to keep the overall portfolio allocation on target.
Since Guideline manages only qualified accounts, and funds remain inside the account when rebalancing, no taxable event is caused by these sales and purchases.

Why does Guideline follow one portfolio allocation?

With traditional 401(k) providers, you can usually decide to change your investment allocation for future deposits, while keeping your current allocation intact. Guideline doesn't provide for this option because we don't believe it makes sense for your retirement portfolio. When a participant goes through our suitability process, we assess time horizon and risk tolerance with their retirement goal in mind and recommend a portfolio allocation we believe is correct for their specific situation. This portfolio allocation becomes the "target allocation" for the retirement portfolio, and all assets in the retirement portfolio should be invested accordingly in order to reach that goal.

Given this intent, there is rarely a reason for future contributions to be allocated differently from current holdings. Instead, if the target allocation changes for some reason, the entire portfolio should change. In other words, you should think of your retirement savings as one whole portfolio, instead of breaking it up into what has been invested during different periods of time.