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A Primer on Portfolio Rebalancing

If you’re a successful long-term investor, you take great care in aligning your investments to an asset allocation that’s appropriate for your goals. Shouldn’t you care just as much about keeping that asset allocation on target? The “buy and hold” approach to investing appeals to many, and for some good reasons. But the fact is, within any portfolio, some holdings will go up in value, and others will go down. That could leave you with an out-of-balance portfolio, which could expose you to more risk than you want. Many investors attempt to mitigate this issue through portfolio rebalancing, or the practice of buying and selling securities to bring a portfolio back to its target allocation.

Let’s say you choose an asset allocation strategy of 50% stocks and 50% bonds to maintain a moderate risk profile. If the stock market were to dramatically outperform the bond market, your portfolio might start looking more like 60% stocks and 40% bonds. That could be good news—your stocks are doing well. However, the reason you chose a 50/50 allocation in the first place was to maintain a moderate risk tolerance and not be overly exposed to stocks. As such, portfolio rebalancing will require you to sell stocks and buy bonds in the right quantities to regain your 50/50 target allocation.

Why Should You Rebalance?                                         

First, rebalancing helps you mitigate risk by bringing your portfolio back to its target allocation. And if your risk profile changes over time, a steady discipline of periodic rebalancing ensures that you monitor and revise your allocations as necessary.

As pointed out in a recent Forbes article, rebalancing also forces investors to buy low and sell high, which is a wise investment strategy that many people don’t follow. Behavioral finance research suggests that most investors are considerably more likely to buy high and sell low. Implementing an automatic rebalancing strategy can help to eliminate this potentially harmful investing practice.

Rebalancing can also reduce portfolio volatility by selling into momentum and buying underperforming asset classes. While reducing volatility isn’t a goal for all investors, it is for many—particularly those in or nearing retirement and maintaining a portfolio of bonds and cash in addition to stocks. During bear markets, rebalancing can be particularly effective, as that is typically the ideal time for long-term investors to add to the stock portion of their portfolios.

A great historical example of a time that rebalancing would have been extremely effective is the market decline of 2007-2009. From September 1, 2007 through March 1, 2009, the S&P 500 lost more than half of its value.[1] However, it more than doubled over the following 4 years.[2] If a 50/50 (stocks to bonds) investor were systematically buying stocks on the way down through rebalancing, he would have generated significantly better percentage returns than a person who simply held that portfolio without a rebalance throughout the decline and subsequent rise.

A Question of Frequency

So how often should you rebalance? Calendar rebalancing is generally done either annually, semi-annually, or quarterly. Percentage rebalancing is done when a target asset allocation moves by a certain amount, sometimes in the 5% range. Either of these strategies can accomplish the goal as studies show there is not an optimal frequency when selecting a rebalancing strategy. Investors should be aware that rebalancing too frequently could result in increased taxes and potentially higher transaction costs.

It’s important to point out that there are cases in which rebalancing can have a negative impact on portfolio performance. In long bull markets—such as the one we’re in now—rebalancing on an annual or quarterly basis could slowly reduce your overall return. If you’re the sort of investor who wants 100% stock exposure with maximum volatility, rebalancing may not be appropriate for you. For this example, rebalancing every other year rather than every year can partially solve this problem, as the less frequently you rebalance, the more volatility you’ll be exposed to. That said, if a market correction is looming, keeping your rebalancing strategy in place may prove wise down the road.

In the world of individual portfolio management, active strategies such as picking individual stocks and trying to time market moves often results in frustration, underperformance, and added cost. Rebalancing is one of the few strategies investors can implement that may be helpful in maintaining one’s tolerance for risk, helping to buy low and sell high, and leveling out some market volatility.

[1] As measured by the SPDR S&P 500 Index from September 1st, 2007 through March 1st, 2009 (-50.81%)

[2] As measured by the SPDR S&P 500 Index from March 1st, 2009 through March 1st, 2013 (+108.34%)

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