Accumulation phase and rebalancing

[Cal]

I'm just starting to build up my investments and I'm DCA into my funds. However, I'm wondering about how I should go about rebalancing.

As an example, I want to keep a 50%/50% split between domestic and foreign stocks. My domestic stock fund has been flat, but my foreign stock fund has taken off. The split right now has moved to 62% foreign/38% domestic.

Which would you do and why:

1. Sell enough of the foreign fund and move it to the domestic fund to get back to the 50%/50% ratio.

2. Temporarily stop contributing to the foreign fund and put my monthly investment into the domestic fund until I reach the 50%/50% split.

My preference is for the second option as I would prefer not to continue buying the foreign stocks at the higher price and put more money towards the (relatively) cheaper domestic stocks.

Am I missing something here?
Thanks.

[cute fuzzy bunny]

Selling your appreciated foreign funds will create a capital gain that you'll be taxed on.

That would be a good thing if we're talking about a modest amount of money and wont give you a big hit this year...if your tax level is reasonable. You could pay niblets of the gains each year rather than in one big lump during withdrawal.

Bad thing if the gain would put you into a 30%+ bracket.

DCAing your contributions into the less appreciated fund would be a good idea.

Another small contribution would be to see if the foreign funds distribute much in the way of dividends or capital gains at the end of the year. If they do, and your broker allows it (vanguard does), set your fund distribution options for the dividends and gains to be reinvested into the US fund. Since these distributions generate taxable income anyhow, you're going to pay for them. Might as well reduce your gains from selling. Might only be 2% or 3%, but it might matter...

[wabmester]

I think the arguments in favor of rebalancing are pretty tenuous, but the main argument is that it forces you to sell appreciated assets and buy less-appreciated assets.

I'm not aware of any study that has looked at your approach (2) -- I think most of the literature assumes you pick some frequency and sell one asset class to buy another asset class in one fell swoop.

[Nords]

1. One "benefit" of rebalancing is that it forces "buy & forget" investors to sell while they're ahead instead of holding on all the way to the bottom. If you're willing to keep an eye on the foreign fund and ruthlessly rebalance back to your asset allocation as soon as the fund falters, then you could keep riding that winner until it drops about 5%. Then sell it to rebalance.

2. This is "value averaging". You're putting more money into the less-performing assets. If you can hold/watch the foreign fund while you're VA'ing into the domestic fund, then ideally you'll keep trying to catch up to the foreign fund for years!

[preben]

Good points on re-balancing. If in a tax free account (401k or just being offshore like me) there is no taxes to worry about.

I believe that the less on touches ones investments the better (as long as set up properly from the start) - but the mechanical re-balancing is the one thing I like doing. Not only does it as mentioned ensure that one sell high/buy lower most times, but it also gives (me!) a feeling of involvment I would otherwise not have - making me do other , more stupid, things in my portfolio.

Cheers!

[brewer12345]

It depends on your tax consequences. If we are talking about tax-deferred accounts, I would probably pick a date once or twice a year and routinely sell enough of the appreciated fund and buy the lower one to get back to target allocation, and just keep the contributions flowing. The more mechanical you can make this process, the less opportunity there is for "operator error" and emotions to creep in.

If we are talking about a taxable account, I would probably just change my contributions.