"Can you please discuss portfolio balancing? I would like to know how to coordinate a yearly balance with my current investment practice of buying mutual funds on a monthly basis, for the same amount each month."
I am sure you are not alone in this question, and I am glad you asked it. What is most encouraging is that by the nature of your question alone, it demonstrates that you have an investment plan in place. Without a plan, rebalancing would be impossible because we wouldn’t know what to rebalance too. Enough philosophy—let’s dive into your question.
I think it is easiest to answer your question with a simple example. Let’s say that you have $100,000 of money that you wish to invest. Your investment plan is extremely basic. You intend to split your investments by putting 60% of your assets in stock and 40% in bonds. Obviously, you would have $60,000 in stocks and $40,000 in bonds based on your plan.
A year from now, we hope that both the stocks and the bonds appreciated, but we know that isn’t always going to be the case. For this example, we will be optimistic and assume your stocks are now worth $72,000 and your bonds are worth $43,000 for a total of $115,000. However, you now have 62.6% (72,000/115,000) of your assets in stock and 37.4% (43,000/115,000) in bonds. Remember our plan calls for us to have 60% in stocks and 40% in bonds. Therefore, we need to “rebalance” to get back to our targets. What can we do?
We could sell some of the stocks and buy bonds with proceeds. If we sold $3,000 worth of stock and bought $3000 worth of bonds, we would be back to our target of 60% (69,000/115,000) stocks and 40% (46,000/115,000) bonds.
Instead of selling and buying, we could just buy more of the bonds to bring up the percentage of the bonds in our investments. For instance, what if we bought $5,000 worth of bonds at the end of the year with money you had in a savings account? We would now have $72,000 in stocks and $48,000 in bonds for a total of $120,000. We would be back on target with 60% (72,000/120,000) stocks and 40% (48,000/120,000) bonds.
Which one should you do? Well, that is easy. If you have $5,000 available to “rebalance” your portfolio in the above example, I recommend doing that. If you don’t have the funds available or they are needed for an emergency fund or to pay off debt, you should sell the stocks and buys the bonds. Just be aware that if this money is in a taxable account there will be taxes due if you recognized any gains. There may also be more transaction costs associated with this approach.
Rebalancing is important in any well-constructed investment plan. I used a simple example but this same math can be done whether you use just stocks and bonds or if you have a plan that uses a large variety of different investments.
I also want to make sure I address the second part of your question. If I understand it correctly, it sounds as though you will be making continual contributions throughout the year as well. Perhaps this is through a 401(k) contribution taken from your paycheck on a monthly basis. You should try to maintain your target even with these contributions. If I use my example above, make it so that 60% of your contributions are going to stocks and 40% are going to bonds. I know this is easier said than done especially if you have a variety of accounts, may not like all your options within a 401(k), etc. This is where it becomes more art than science. Just remember your goal is to maintain that target. At the very least, do not let the percentages get too far out of whack. At the end of the year, all that matters is that you rebalance according to your target as explained above. You may or may not choose to revise how your contributions are being invested at that time as well.
I know this was a long post. I hope it was helpful. Please let me know if you have any additional questions.