There is a good reason for the importance of rebalancing a portfolio is emphasized. Not only does rebalancing allow you to buy your stock and bond mutual fund shares at a lower price, but it also forces you to sell at a higher one. Rebalancing may also boost returns by a quarter percent or so. But, how do you rebalance a 401(k) portfolio?
Look at Whole Investment Pie
A frequent mistake investors make is not looking at their whole investing pie. When considering your asset allocation, imagine that the assets in every one of your investment accounts are actually in one account. The one big account includes your 401(k), Roth or traditional individual retirement account (IRA) and your taxable investment brokerage account holdings.
Picture your investments and accounts like a strawberry, banana and rhubarb pie. You don’t have one section for the strawberries, another for the banana and a third for the rhubarb. All the ingredients in your accounts go into the asset allocation pie.
Kendra is in her early 30s and relatively aggressive. Her asset allocation is 75% stock funds and 25% bond funds. She divides her three stock funds equally. This yields an asset allocation of 25% in each mutual fund. Note: For the asset allocation conversation we’re not talking about the accounts.
Kendra had two separate investment accounts with various investments in each. Her asset allocation is 75% stock mutual funds and 25% bond mutual funds.
Here are the details for each of the accounts at the beginning of the year:
Account 1: 401(k) $10,000
- $5,000 Vanguard Total Stock Market Index Fund (VTSMX)
- $5,000 Vanguard Total Bond Market Index Fund (VBMFX)
Account 2: Fidelity Brokerage Investment Account $10,000
- $5,000 Fidelity Spartan Global Ex-U.S. Index Fund (FSGDX)
- $5,000 Vanguard Dividend Growth Fund (VDIGX)
Total investment assets = $20,000
Here’s a detailed breakdown of her total investment portfolio preferred asset allocation, including account values:
- 75% Stock Investments: $15,000
- 25% Bond Investments: $5,000
Her portfolio was perfectly balanced at the beginning of the year. By the end of the year, some funds advanced, while others lagged.
Here’s how her asset values looked on Dec. 31.
Account 1: 401(k) $11,150
- $5,900 – Vanguard Total Stock Market Index Fund (VTSMX)
- $5,250 – Vanguard Total Bond Market Index Fund (VBMFX)
Account 2: Fidelity Brokerage Investment Account $10,900
- $5,300 – Fidelity Spartan Global ex U.S. Index Fund (FSGDX)
- $5,600 – Vanguard Dividend Growth Fund (VDIGX)
By the end of the year, due to the changes in the asset values, her investment portfolio value grew from $20,000 to $22,050 for an annual capital appreciation of 10.25%. At the end of the year, her asset allocation became:
- 76.2% Stock Investments: $16,800
- 23.8% Bond Investments: $5,250
In keeping with her preferred asset allocation, the new portfolio value by asset class should be:
- 75% Stock Investments: $16,537.50
- 25% Bond Investments: $5,512.50
The goal of asset reallocation is to return the asset class percentages to the predetermined asset allocation.
Ideally, during January, Kendra will rebalance to get back to her original asset allocation. She’s not sure how to optimally buy and sell funds to rebalance her 401(k) account. Up until now, we’ve looked at her total investment portfolio. Now, let’s break out the 401(k) account.
Rebalancing the 401(k)
After rebalancing back to the original 25% in each mutual fund, here’s how the 401(k) account should be valued:
- $5,512 ($22,050 * 0.25): Vanguard Total Stock Market Index Fund (VTSMX)
- $5,512 ($22,050 * 0.25): Vanguard Total Bond Market Index Fund (VBMFX)
Here’s the value of the 401(k) account before rebalancing:
- $5,900: Vanguard Total Stock Market Index Fund (VTSMX)
- $5,250: Vanguard Total Bond Market Index Fund (VBMFX)
In order to rebalance back to the original asset allocation of $5,900, Kendra should sell $388 worth of shares in the Vanguard Total Stock Market Index Fund ($5,512 - $5,900) to return to the preferred 25% of total portfolio value of $5,512. She should buy $262.50 of the Vanguard Total Bond Market Index Fund to reach the 25% asset allocation percent or $5,512 value ($5,512 - $5,250).
The rebalancing is actually very simple. You determine the amount that’s needed to be bought or sold of each fund in order to return to the preferred asset allocation. In a 401(k), you buy or sell the appropriate number of shares through the account’s trading platform.
If you don’t want to buy and sell shares to return to the desired allocation, you can adjust your future contributions to contribute more to the Vanguard Total Bond Market Index Fund and decrease the contribution to the Vanguard Total Stock Market Index Fund. Over time, depending on how the markets perform in the ensuing year, this will move your investment values toward the desired asset class percentages.
The Bottom Line
Rebalancing is not an exact science. Since asset values move daily, even if you rebalance once a day, by the next there will be a slight deviation in your asset allocation. Thus, a "good enough" asset allocation is appropriate. Since Kendra’s portfolio wasn’t too far off the mark, she might consider doing nothing and wait a few months before revisiting the rebalancing decision.