The Importance of Rebalancing Your 401(k)
Soon, 401(k) investors will begin receiving quarterly statements to summarize the performance of their retirement account. The first thing many investors look for is the rate of return, and rightly so, it directly impacts the amount of money available for retirement. Investors also understand that the amount of risk they take will impact the returns they experience. For this reason, more focus should be paid to managing risk, rather than managing returns.
The fundamental method of risk management is in the asset allocation decision, which involves the process of deciding how money should be allocated between asset classes - stocks and bonds, foreign and domestic holdings, and large caps versus small caps. This decision becomes increasingly more important in volatile market environments.
The appropriate investment strategy is influenced by many factors, such as: investing time horizon (how long the money is invested), and the investor’s objectives, goals and risk tolerance. It is important that these factors are decided upon before making any long-term investment decisions. If you find yourself struggling with this step, it is important that you get some help.
The purpose of this article, however, is to evaluate what to do after this step. Before we proceed, please understand that from this point forward, the assumption is that you have already completed this thorough process.
Once you have decided on the right mix of asset classes for you at this particular moment, it’s always a good idea to revisit your account on a periodic basis. We suggest four times a year, once per quarter, to make sure that your allocation doesn’t move too far from the intended target.
Overtime, if left unchecked, your balances in each of the asset classes will stray away from the initial target allocation as the various sectors of the market perform differently. For example, let’s say you start with an allocation of international funds at 15 percent two years ago. This asset type has performed well over this time period, so now it makes up 20 percent or more of your total portfolio. The result: you now are more aggressive than you intended to be, and the risk builds that the well-performing sector may revert back to its historical mean return. A great resource for how asset classes have performed over time is shown in The Callan Periodic Table of Investment Returns:
http://callan.com/research/institute/download/?file=periodic/free/256.pdf
This chart shows the annual rank and return of each asset class from 1988 to 2007. Notice that the top performing asset class for the past three years, the “MSCI EAFE” (international) index, was also the worst performing asset class in seven of the 13 years from 1989 to 2001.
The idea here is that no one asset class is always the best performer, or even a good performer. I know it’s hard to sell an investment that’s doing well, but essentially you are selling high and buying low when you take this approach. According to findings from DALBAR’s study of Quantitative Analysis of Investor Behavior (QAIB), the average investor’s return is far less than the S&P 500 index return, which is in large part due to unsuccessful market timing. This shortfall is often caused by the tendency to gravitate towards areas of the market that have the best recent (short-term) performance.
Lesson learned: Be diversified across major asset classes, continue to invest in all market cycles (dollar-cost averaging) and periodically rebalance the account to make sure that your investments stay aligned with your long-term investment strategy. Some plans are now offering an automatic rebalance feature that lets you select the frequency your account is reset back to the original allocation. One word of caution with this feature is that you don’t completely forget to look at your account again, and remember, that you must take prudent action to decide how the investments should be allocated in the first place.
Managing your own investments can be hard sometimes, especially in periods of high market volatility. We think you will have a lot more success, and will rest much easier, if you follow this systematic approach to investing. A sound investment strategy and rebalancing schedule will be your guide, rather than letting fear and emotion lead you to an inevitable journey of irrational decisions.
If you feel you need help with this area of your investment strategy, or at least want a second opinion, please give us a call at (877) 627-8401.
Kevin Jaegers, Senior Investment Advisor
