What Is Rebalancing?

I am not a finance expert. I am not an investment expert. I am someone who pays attention when one of these people makes a suggestion that will affect my retirement investments, however, which means I rebalanced my 401(k) last week.

Yesterday, I was talking to someone who received the same advice I did. She said, "I haven't rebalanced yet. Maybe I don't understand, but it seems to me like a way to lock in losses."

She was right. She didn't understand. And if she didn't understand, despite having a background in math, someone reading this probably doesn't understand either. I think she got it after I explained it to her, so I'll throw my explanation out here too.

You can ignore this if you have your retirement investments in a target-date fund. They do the rebalancing for you. You can also ignore it if the idea of looking at what the stock market plunge has done to your money makes you queasy. If so, get into a target-date fund and forget about the money for a while.

In short, rebalancing between stocks and stable value (usually bond) investments means that when stocks grow, you squirrel away some of your gains in the stable value funds to protect them in case the market goes down. If stocks decline in value, bonds usually get more attractive to investors, so rebalancing is your way of using some of the bonds' increased value to buy stock on the cheap, while it's possibly undervalued.

Let's say you're an investor with 30 years to go before retirement. You set your investments up so new funds coming in go into 10% stable value, 40% large cap stocks, 30% small cap stocks, and 20% international stocks. At the end of a year in which all your investments are growing but domestic stocks have a large upswing in value, your actual funds might be 7% stable value, 42% large cap stocks, 35% small cap stocks, and 16% international stocks. If you rebalance to your original allocations, you move 2% of your funds out of the large cap and 5% out of your small cap to stick 3% in your more-protected stable value fund and 4% in international stocks, which can outpace domestic stocks in growth in the next year just by catching up to them in value.

The numbers aren't quite as dramatic, but that's more or less what I did at the end of 2007. That means I moved money out of stocks before they started falling in January. Last week, after the panic sell-off of stocks, I rebalanced again. I ended up buying cheap stocks. Sure, I did it before another round of panic, but it beat waiting until they were going up again.

If you have an investment adviser, by all means, ask them what you should do. If you don't, well, the advice I got was that now is the time to rebalance. What are you waiting for?