Do you rebalance your 401K portfolio every 12-18 months or following a significant market move? You should and here’s why!
It is Time to Rebalance Your 401(k) Plan
If you are like most people, your 401(k) plan is your largest investment asset and the ultimate key to your financial security. Yet, few people bother to review their plan beyond a brief glance at their quarterly or annual statements.
You might ask, "What’s the point as long as the markets continue to hit new highs, and the value of my plan continues to increase?" What you do not know is there may be dangers lurking in your plan that could be putting your money at risk. A strong market like the one we are now experiencing can bring great returns, but it can also increase your risk if your asset allocation no longer reflects your investment profile. That is why it is important to rebalance your 401(k) once a year or after there has been significant movement in the market.
You Choose an Asset Allocation for a Reason
When investing in a 401(k) plan, it is essential to allocate your funds according to your target asset allocation. Your asset allocation is your chosen mix of assets based on the amount of risk you are willing to take to generate a certain level of returns. For example, if your risk profile is conservative, it means you are willing to accept lower returns because you do not want to take a lot of risk in your portfolio. Depending on how close you are to retirement, that might translate into a 40/60 asset mix between stocks and bonds. If you are willing to assume more risk for the possibility of generating higher returns, your asset allocation might look more like 60/40 with a heavier weighting in stocks.
A Misaligned Asset Allocation Increases Your Risk
Within each asset class, there are different levels of risk/return. For instance, if you allocate 60% of your portfolio to stocks, you may invest equally among a more conservative blue-chip stock fund, an aggressive small-cap stock fund, and an international stock fund. Let’s say the stock market performs well, and small-cap stocks outperform all other classes of stocks. You look at your stock portfolio, and, instead of being equally weighted among the three funds, your small-cap fund has grown to comprise 50% of your stock portfolio.
By virtue of small-cap stocks’ strong performance, your stock portfolio is now exposed to more risk because small-cap stocks tend to be much more volatile than other stock classes. If you want to return your portfolio to the risk-return profile you started out with, you will need to rebalance your asset allocation.
Let’s say you are a conservative investor with a 40/60 stocks/bonds allocation, and the stock market rises by 30%. That is great for your portfolio value, but your allocation has changed to 60/40, which introduces more risk than you are willing to assume. If you do not rebalance your portfolio back to 40/60, you will be outside your risk comfort level, and, in the next stock market downturn, your portfolio value could suffer a much more significant decline.
Rebalancing Keeps Your Asset Allocation on Target
When you rebalance your portfolio, you are merely realigning your assets back to your target allocation to maintain your desired risk-return profile. At its simplest, you sell securities that have become overpriced and buy securities that have declined in value. For a conservative 40/60 allocation, it might mean selling a portion of your stock funds and buying additional shares of your bond funds. It would be best if you rebalanced your portfolio once every 12 to 18 months or following a significant market move to prevent unwanted risk from seeping into your portfolio.
Some 401(k) plans have an automatic rebalancing feature. If your plan does not, check with your plan sponsor for tools or resources that can help you keep your target asset allocation in place.
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