Portfolio Rebalancing

It is common for investors to shun stocks after a large market decline. At that moment they are likely underweight stocks compared to the targets set forth in a carefully crafted investment policy statement and financial plan. But fear tends to dominate logic at such times.

Disciplined rebalancing of an investment portfolio is the practice of buying and selling investments to keep a consistent asset allocation over time. This is accomplished by first setting a target asset allocation, then periodically comparing your portfolio against those targets and selling what is overweight and buying what is underweight.

Here is an example using the market decline of 2008. If an investor had $1,000,000 split evenly between stocks (S&P 500) and bonds (Intermediate Government Bonds) at the beginning of 2008, by year end they would have suffered a total loss of 15.4%.

In 2009, the stock market rebounded. For those investors who rebalanced their portfolio the combined performance for the two years was a loss of 2%, versus a loss of 4.3% for those investors who did not rebalance. See the table above.

The benefit of rebalancing is that it produces a disciplined buy low/sell high mechanism that does not rely on market timing. Its main function is to reduce the risk of the portfolio. If a portfolio was not rebalanced for an extended period of time, it would eventually become dominated by stocks and other growth assets since they have a higher long term expected return. But this moves in the opposite direction of the majority of investors' needs. As people get older they tend to need less volatile investments to fund retirement distributions.

So why wouldn't everyone rebalance their portfolio? For many, the emotional toll of buying when stocks are down (fear) or selling when stocks are doing well (greed) is too taxing. For others they don't have the knowledge or time necessary to effectively manage their investments.

This chart compares the average returns and worst single year since 1926 of government bonds and the S&P 500 to a 50/50 stock/bond mix. The worst year for the 50/50 mix is about half that of the S&P 500, as you would expect. But the 50/50 return was 0.5% better than the average of bonds and stocks, 8.1% vs. 7.6%; this extra half percent per year is the long term benefit of disciplined rebalancing. 

Ignoring emotion and pursuing the discipline of regular rebalancing keeps a portfolio’s risk from drifting higher over time. Moreover, the automatic “buy low/sell high” nature of rebalancing tends to add additional return.