In an earlier post I talked about determining a desired asset allocation based on the goal and time to get there.  Due to normal market fluctuations, your portfolio will not continue to maintain this allocation on its own.  Traditional advice is to review your allocation periodically (every 3, 6, or 12 months) and make transfers between accounts accordingly.  This is a fine approach, but does run some risk of selecting the wrong time to make large investments–making a large transfer just before a big turn-down in the asset.  Good advice for regular investments is the concept of dollar cost averaging, which is a complicated term for something very simple, regularly invest a set number of dollars, not a set number of shares, which will help even out the prices you pay for an asset.  You can take a similar approach to rebalancing.

An approach for a 401k (or any other investment where you are making regular contributions) is to ‘rebalance by contribution’ meaning use continuing contributions every 2 weeks to try to get back to the ideal allocation.  For example, lets say I have the following for my investment in the Vanguard Total Stock Fund:

For the example case, the normal contribution for the Vanguard Total Stock Fund would be 60% of the total contribution (60% of $300, or $180).  This is then offset by the fact that I’m currently overweighted in this fund by 1%, or

$180 + (-0.01 x $100,000/20) = $130

In other words, I’m adjusting my contribution down due to the fact that I currently have “too much” of this asset class.  Other underweighted funds, using the same approach would be adjusted up.  This can be updated with each contribution period (provided you keep up with your current allocation) and done for each investment.  Note, sometimes the contribution may actually be a negative number, meaning you should be transferring that amount of money out of the fund at that contribution time, to another fund that is underweighted.

This approach makes you buy less of the assets that have grown in value and more of what has fallen, hopefully leading to buying at a lower cost, similar to the wisdom of dollar cost averaging.  Admittedly, this is a bunch of work that you might not want to do, I’m a bit of an obsessive on this, and if you’d rather just do the periodic rebalancing (lump sum transfers back to your ideal allocation) every 6 months or so, that is OK too.