Whether the Market Is Overvalued or Not, It Can Pay to Rebalance

Current valuations of U.S. stocks inevitably lead to debate over their prospects for future returns, earnings sustainability, and whether we are in the midst of a stock market bubble.  Some measures indicate the market is richly valued by historical standards, but no one knows what the future holds.  However, one thing is clear—the potential value of rebalancing defined contribution retirement accounts.  As discussed in a recent PlanSponsor article by John Manganaro,[1] record 401(k) balances and equity performance could be skewing retirement accounts to higher equities allocations.  Plan participants can take advantage of automatic rebalancing if their plans offer it, or rebalance themselves if they have not done so recently.  Of course, rebalancing may result in transaction costs, so it should be assessed in light of the costs and benefits.

Retirement accounts that have not been rebalanced in a significant period of time would probably be good candidates for review.  For example, if never rebalanced, a portfolio that allocated 70% to the S&P 500 and 30% to the S&P U.S. Aggregate Bond Index as of June 2012 would have over 80% of its weight in stocks as of the end of June 2017.

Suppose your target allocation in 2012 was 70% stocks and 30% bonds.  Your account would be overweight in equities by over 10% if your target were still 70%.  But if you are approaching retirement, perhaps your new target is a lower stock allocation, such as 60%.  That would mean your account is more than 20% overweight in stocks.  That could represent a lot of unintended risk if you don’t take the time to rebalance.

Many of the challenges in achieving investing success come down to discipline.  Avoiding overreactions when markets soar or dive, diligently saving, being aware of costs, diversifying within and across asset classes, and sticking to a reasonable investment policy that includes periodic rebalancing will go a long way toward reaching success.  With automatic rebalancing and the prevalence of target date funds in 401(k) plans, many plan participants can automate these steps.  But for those who do not or cannot, it is wise to monitor investment allocations and rebalance when actual allocations differ substantially from one’s investment policy.

[1] http://www.plansponsor.com/Record-Balances-May-Skew-DC-Accounts-Towards-Equity/

The posts on this blog are opinions, not advice. Please read our disclaimers.

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