Index Investing: Maintenance

|| This article is Part Seven in a series on investing with index mutual funds. ||
||   I. SpeculationII. Index FundsIII. John BogleIV. Vanguard   ||
||  V. Moving to VanguardVI. Asset AllocationVII. Maintenance  ||

When set up correctly, your investments should require very little maintenance.  There's no need to check on your account regularly, but it's a good idea to rebalance your portfolio and reevaluate your contribution rate every now and then.
Nearly time for a rebalancing?

The Beauty of Automatic Investments

In the business world, the rearview mirror is always clearer than the windshield. -Warren Buffett

The human mind is susceptible to tricks of perception that make it exceedingly easy to commit serious investment mistakes.  When markets are on fire and every number is going up, up, up, people rush in to buy more securities and take bigger risks; when the market dips and you've lost money, holding the course and committing additional funds can be a hard pill to swallow, even though this is precisely the moment that the investments are 'on sale'.

The best way to protect your finances from the vagaries of your emotional state is to automate the investing process as much as possible.

Every brokerage offers the option to schedule automatic transfers from your bank account to your investment account to buy more shares of one or more mutual funds you already own.  The minimum additional mutual fund investment is only $100, and Vanguard offers a highly customizable investment schedule:

If you're investing into a Roth IRA with an annual contribution limit, Vanguard even gives you the option to automatically adjust the investment size to ensure you contribute up to the limit by the deadline.

It's not possible to trade fractional shares of Exchange-Traded Funds (ETFs), so automatic investing isn't an option.  This is the primary reason why I don't recommend ETFs for everyday investing, despite their slightly lower expense ratios.

Adjusting Your Contribution Rate

Have enough cash in the checking account to cover your usual expenses?  Have a well-provisioned emergency fund?  Set your automatic contribution rate to invest the rest.

Check in once a quarter to make sure that your contribution rate still makes sense.  If you've cut your expenses, increased your income, or come upon a windfall, adjust your contribution rate to mobilize this additional cash.

Rebalancing Your Portfolio

Remember when we figured out which funds to invest in and in what proportion, to fine-tune your portfolio's risk/reward balance and other factors?  Some things go up, some things go down, and before long the market has totally screwed up your proportions.  While this is basically the point of asset allocation—after all, it wouldn't be diversification if the value of your investments tracked eachother perfectly—you should occasionally rebalance the ratios.

You could simply sell a bit of the funds that have grown in proportion and use the assets to purchase more shares of the others.  Alternatively, adjust your automatic contributions to direct new money into the funds that need a boost.  This method is especially effective when you first start investing and your contributions are still large compared to the total amount you have invested.  It has the added advantage of avoiding any selling, and therefore having zero tax consequences when performed in a taxable account.

Quarterly is too often to be worrying about rebalancing.  Once a year on a set date is a reasonable policy; I do it on the same day I pull my free credit reports.

If you hold Target Date funds, they are automatically rebalanced.

If you have several accounts, don't forget to consider your asset allocation across all of them.

And that's it!  Just improve your savings rate and keep shoveling money into your investment accounts, and it should pay off in the long run.