PORTFOLIO rebalancing — periodically resetting a mix of stocks and bonds by taking profits from outperforming investments and buying cheaper, underperforming ones — has always posed a challenge.

Rebalance too often and you’ll sell profitable investments too soon and miss out on big gains. But wait too long and the market will alter your strategy and risk profile in ways you may never have intended.

If the stock market has been rising, for example, you may be holding way more stocks than you’re comfortable with. If the bond market has been climbing, you may have gone too far in the fixed-income direction, even though you want to own more stocks.

In some ways, today’s market has made rebalancing even trickier. Since the start of 2012, a basic stock fund that tracks the Standard Poor’s 500 index has soared 29 percent, while a typical bond portfolio has returned less than 5 percent. Traditional rebalancing would dictate that investors sell some of their surging equities, thus keeping their portfolios from becoming too stock-heavy and risky. This would be a particularly important safeguard for investors if the bull market is nearing an end.

That money, then, would be used to bolster allocations to fixed-income investments. Yet market analysts note that with 10-year Treasury securities now yielding just 1.7 percent, bonds are about as richly priced as they’ve been in decades.

So should investors use discipline and stick with their plans, even if that means buying bonds they think are expensive? Or should they adhere to the lessons of the last decade by refusing to buy investments they consider overpriced? Just as there’s no right answer about how often to rebalance — studies are inconclusive about whether it’s better to do this quarterly or annually — financial planners and market analysts say that no single answer suits all investors.

Instead, there are several basic options.

The first strategy is to stay the course and rebalance if your portfolio is out of whack — just tweak the types of bonds you buy. Mark R. Freeman, chief investment officer at the Westwood Holdings Group, notes that the primary rationale for rebalancing is to manage the overall risk of a portfolio. Just because investors are wary of bonds is no reason to let their portfolios become overexposed to equities, which are likely to lose far more value than bonds in a market correction.

Harold R. Evensky, president of Evensky Katz Wealth Management, agrees. “The idea is to maintain your investment policies, but to adjust to market conditions,” he said. “For instance, you could always shorten your duration,” he noted, meaning that you could rebalance into bond funds that invest specifically in short-term securities, which are less likely to lose value should interest rates rise and bond prices fall.

Judith B. Ward, a financial planner at T. Rowe Price, said picking and choosing where to redeploy that rebalanced money might be fine for experienced investors who closely tracked the markets and their portfolios. For less engaged investors, though, she said there was a simpler approach: rebalance now if it seems time to do so, but just make sure that the money going into fixed income is extremely well diversified across all major areas of the bond market.

“If you diversify, and have exposure to international and domestic bonds, government and corporate securities, and bonds of different durations,” Ms. Ward said, “your bond portfolio is probably not going to suffer as much as you might think in a worst-case scenario.”

But there’s a catch here, too.

Many people, particularly those who invest primarily in their 401(k) retirement plans, are likely to turn to a so-called total bond market index fund to diversify their fixed-income holdings.

“There is a perception out that there that if I own one of these index funds, I own the total bond market,” said Kathy A. Jones, a fixed-income strategist with the Schwab Center for Financial Research.

That’s not the case. Many bond funds mirror the Barclays U.S. Aggregate Bond index, which includes very little non-United States debt as well as relatively few high-yield or junk bonds. Around 75 percent of the index tracks government securities or other types of government-backed bonds. Less than 25 percent is in corporate bonds.

“At the end of the day,” Ms. Jones said, “these funds may own a lot of different bonds, but you don’t get much issuer diversification, and you’re getting that at very low yields.”

Because of this, says John C. Bogle, founder of the Vanguard Group, total bond indexes “are deeply flawed — and that’s coming from an indexer.”  He adds that individual investors should keep only about one-third of their bond stake in Treasuries and government debt, reflecting the market’s mix based on private investors such as pension and mutual funds.  

Investors might consider keeping half their money in a total bond market fund, he said, while shifting the other half to an intermediate corporate bond fund. By doing so, investors would end up with an overall strategy that’s about two-thirds in corporate debt and one-third in government securities.

As far as rebalancing goes, Mr. Bogle notes that there is another option: hold off. “Rebalancing is something I don’t think anybody should follow slavishly,” he said.

To be sure, annual rebalancing can keep a portfolio from veering drastically off course over time. For instance, heading into the 2008 market plunge, more than one out of five 401(k) investors aged 56 to 65 held more than 90 percent of their retirement accounts in stocks. Presumably, many got to that risky allocation by failing to rebalance.

But Mr. Bogle says that over very long periods, rebalancing doesn’t necessarily pay off, because investors are constantly selling out of higher-performing assets.

A compromise is to set basic thresholds. Rather than automatically rebalancing each year, investors can just establish a range — say, of five percentage points or more around their allocation target. So you don’t have to rebalance back to, say, 60 percent stocks until that weighting hits 65 percent or even higher.

At the least, he said, “Don’t say, ‘Oh my God,’ I’m up to 60.4 percent stocks and I want to stay at 60.’ ”

Paul J. Lim is a senior editor at Money magazine. E-mail: fund@nytimes.com.

Article source: http://www.nytimes.com/2013/04/28/your-money/the-stock-and-bond-mix-is-tough-to-rebalance.html?partner=rss&emc=rss