Step 9: Keep Your Balance

ONCE YOU’VE BUILT your portfolio of low-cost index funds, benign neglect is the best strategy. But you shouldn’t neglect your portfolio entirely.

Every year or so—or after big market moves—look to rebalance your portfolio. This isn’t something you need worry about if you opt for a one-stop shopping fund, described in step 4. But everybody else should have target percentages for their various fund holdings. For instance, you might have earmarked 40% of your portfolio for a total U.S. bond market fund, 35% for a total U.S. stock market fund and 25% for a total international stock fund. Occasionally, you should check to see if your funds have strayed significantly from these percentages and, if they have, you may want to rebalance.

This involves lightening up on funds that have fared well and adding to those that have lagged, so you get back to your target percentages. Make no mistake: This is far harder than it sounds—because it means buying into investments that are currently loathed—and it’s yet another reason to favor one-stop shopping funds.

Rebalancing is best done in a retirement account, where your trading won’t have tax consequences. What if you need to rebalance your taxable account? You might direct new savings to those funds that have become underweighted. You might also take your various funds’ income and capital gains distributions in cash, and then redirect the money to those funds that have fallen below your target percentages.

If you didn’t rebalance, your portfolio would tend to become increasingly risky over time. Why? Your stock funds will likely prove to be your best long-term investment and, if left to grow unchecked, they’ll come to dominate your portfolio. That means you’ll get hit especially hard when the next bear market rolls around. But there’s a tradeoff involved: Even as rebalancing keeps your portfolio’s risk level under control, it tends to restrain performance, because you’re regularly selling stocks—which should be your best investment over the long haul.

That said, rebalancing during a bear market can help your portfolio to recover more quickly, as you shift out of bonds and into depressed stocks. Rebalancing among different stock market sectors can also boost performance, as you ease up on highfliers that may be set to tumble, while buying laggards that could be ripe for a rebound.

In addition to rebalancing, each year consider selling any investment losers in your taxable account. That’ll generate realized losses than can be used to trim that year’s tax bill. The proceeds from the sale should be immediately reinvested in the same part of the market, though be careful not to run afoul of the wash-sale rule.

While harvesting tax losses gets a fair amount of attention in the financial press and among investment experts, the opportunities to realize losses will be limited for the prudent index fund investor. Indeed, those opportunities will likely only present themselves in your first few years as an investor. Soon enough, your funds will probably be worth more than you paid—and the chance to take tax losses will be over.

Next: Main Menu

Previous: Step 8: Add Alternatives

Notify of
Inline Feedbacks
View all comments

Free Newsletter