It’s easy to assume that merely making regular contributions to your 401(k) account is enough to ensure that you are prepared for retirement. After all, when you first enrolled in the plan you decided what your contributions would be invested in, and simply adding money to the pot will keep those assets growing.
Unfortunately, that’s not the whole story. Your asset allocation can fall out of balance because of changes in the marketplace, and that can leave you over-invested in assets that are either too risky or too conservative for your long-term plans.
This is why it’s so important to understand the different ways you can rebalance your 401(k) portfolio to make sure it’s taking care of you and your money.
What is 401(k) rebalancing?
When you set up your 401(k), you chose a balance of different asset classes to help you reach your retirement goals within your risk tolerance. This is called your asset allocation and it determines what percentage of your money is in each asset class.
But shifts in the market can change the percentages of your asset allocation. For instance, let’s say that you started with 70% of your money invested in stocks and 30% in bonds. If the stock market experiences a downturn while your bonds gain value, you may find that your stock assets are now worth less than 70% of your portfolio and your bond assets are worth more than 30%.
Rebalancing is the process of adjusting your holdings so that your asset allocation returns to the same ratio that you originally planned or would like to be at moving forward.
Rebalancing your 401(k): Five ways to adjust your portfolio
There are multiple ways to go about rebalancing your 401(k) portfolio, and it’s a good idea to familiarize yourself with each one.
1. Calendar strategy
A common way to rebalance your portfolio is to plan a check-in on a predetermined regular basis (annually, bi-annually, quarterly, monthly) and rebalance as necessary. Rebalancing every month can be a little extreme since it will prompt account-holders to rebalance asset imbalances that might smooth out on their own over time. However, using the calendar strategy less often than monthly ensures that you regularly look at your asset allocation balance and manually move funds when an asset’s percentage grows or shrinks from your original allocation.
An additional benefit is that planning to rebalance your portfolio on a regular schedule can help protect you from the temptation to overreact to market changes, since you already have a time set aside to deal with adjusting your asset allocation.
2. Percentage of portfolio strategy
For account holders who prefer to maintain a closer eye on their investments, the percentage of portfolio strategy can be a good way of keeping your allocation in balance. This strategy recommends that you rebalance your assets as needed when they move out of the percentage targets you had assigned for each.
With this strategy, you will monitor your investments over time, and manually move funds from an overbalanced asset class to an underbalanced one whenever there is a misalignment with your allocation strategy.
3. Automatic rebalancing
For investors who prefer to be more hands-off, automatic rebalancing can be an easy way to maintain your portfolio’s balance. While some 401(k) providers will offer periodic automatic rebalancing, you can also set up automatic rebalancing by opting for target-dated funds.
Choose a target-dated fund with a date close to your projected retirement, and the asset allocation is automatically modified over time to go from a growth strategy to a preservation of principal and income-based strategy.
4. Use Constant Proportion Portfolio Insurance (CPPI)
This rebalancing strategy starts with the question of how much of your principal you want to be protected in case of market losses. The amount of principal you want to protect is known as your floor.
The formula for determining how much is invested in risk-free securities and how much in higher-risk stocks is the following:
Risk tolerance multiplier x (Total portfolio assets – Floor) = Stock investments
For instance, let’s say you have a $100,000 portfolio, and your floor is $90,000. Your risk tolerance is the maximum percentage you are comfortable losing in a single day. Let’s say your risk tolerance is 20%. To make that a multiplier, you divide 1 by 20% to get 5. (1/.2 = 5).
That means your stock investments will be calculated as follows:
This means you should allocate $50,000 to the riskier investment, and the remainder to risk-free securities. The benefit of the CPPI method is that as the value of the portfolio grows (and the floor stays the same), more and more money can be placed in the higher-risk investments while still maintaining the floor amount of the investor’s principal.
The downside of CPPI is that it does not specify a timetable for rebalancing. Often, investors will combine the calendar strategy with CPPI to regularly rebalance their portfolio to maintain the floor amount and move any additional funds into the higher-risk/higher-return investments.
5. Rebalance as risk tolerance changes
Risk tolerance describes an investor’s willingness to handle the variability of investment returns. On one end of the spectrum lies conservative risk tolerance. These investors are uncomfortable with the possibility of ever losing principal, even if there is a potential for a big return. At the other end lies aggressive risk tolerance. These investors are comfortable with the volatility of the market because they are chasing big returns.
Risk tolerance does tend to change over time. Younger investors, with more time to recover from downturns, tend to be more aggressive than investors who are nearing retirement. Rebalancing your portfolio as your risk tolerance changes is a common method of helping investors prepare for retirement. As you near retirement, you will likely want to rebalance your portfolio to favor assets that will help you preserve principal and provide income and reduce your exposure to riskier assets that could offer the opportunity for bigger returns.
This kind of rebalancing is also done automatically with target-dated funds, although it is also a good idea to check in on your risk tolerance and asset allocation as you age, even if you have chosen target-dated funds in your 401(k).
Choosing the asset allocation in your 401(k) is not a set-it-and-forget task. It’s up to you to consistently rebalance your asset classes when they fall out of alignment with your original plans, or if they no longer reflect your risk tolerance.
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