The goal of asset allocation is to diversify into different types of investments so that the up and down cycles of the markets are evened out for the total value of your portfolio. Mutual funds allow you to establish an asset allocation plan using several funds such as a U.S. stock fund, an international stock fund, a bond fund and possibly a real estate-focused fund. Rebalancing keeps your strategy intact as the value of each fund account changes.
Buy Low, Sell High
Rebalancing your mutual fund holdings to meet your asset allocation goals is an automatic way to make yourself practice the hard-to-follow adage to buy low and sell high. With a set allocation percentage for each of your mutual funds, when the percentage of one fund gets too high, you will sell that fund and invest the proceeds into a fund that has gone down -- or not up as much. Rebalancing will force you to buy when the markets are down and also make you sell when your investments are up and your emotions tell you to hold on to your fund shares.
You need to set a specific schedule of when to rebalance your mutual fund allocations. One approach is to change your investment amounts on a set time frame, such as quarterly or semi-annually. Another way to determine when it is time to rebalance is at a pre-set percentage change in the allocation of one or more funds. For example, you may rebalance whenever one of your funds is more than 5 percent different than the percentage selected in your allocation plan.
Ways to Rebalance
There are several approaches to change fund allocations when it is time to rebalance. The basic method is to calculate by how much funds are above allocation, sell that amount of shares and invest the proceeds into the funds that are below the target allocation. Another way to balance is to invest more into your fund portfolio by adding to your below-target funds. Also, if you are making regular investments into your various funds, you can change the amount going to each fund to increase the investments to the under-target funds and decrease the amount going to the above-allocation funds.
Buying and Selling Considerations
If you sell fund shares to rebalance your asset allocation, you will probably be selling the funds that have gained the most in value. As a result, you will produce capital gains that must be reported and taxed on your tax return. If you want to take an extra step with your asset allocation, you can calculate how much your fund sale will leave after tax and reinvest that amount, setting aside the other money to pay your tax bill.
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