The Portfolio Rebalancing Act

05/18/2011 11:34 am EST

Focus: GLOBAL

John Heinzl

Reporter and Columnist, GlobeInvestor.com

Keeping your asset allocation in check can help you protect your nest egg and take advantage of market trends, but you shouldn’t do it too often, writes John Heinzl, reporter and columnist for GlobeInvestor.com.

I’ve read that it’s a good idea to rebalance your portfolio, but one thing I’m not clear on is how often I should do this. Once a year? Twice a year? Thanks—D.M.

Before we answer your question, a little background.

Rebalancing refers to buying or selling securities in your portfolio to bring the asset allocation back to predetermined targets. It’s a way to control risk and potentially improve returns.

For example, say you’re a conservative investor with a 50-50 split of stocks and bonds, and your portfolio is worth $1 million. You’ve chosen this allocation because it’s appropriate for your age and risk tolerance.

Now let’s assume your stock holdings rise by 30% and your bonds fall 10%. Your stock component would be worth $650,000 (or 59% of the total), and your fixed-income would have slipped to $450,000 (or 41%).

To bring the components back into line, you could sell $100,000 of stock and use the proceeds to buy $100,000 of bonds, restoring the 50-50 balance.

Alternatively, if you have new money to invest, you could allocate it to the asset class that has dropped in value. The beauty of rebalancing is that it makes investing decisions automatic: You end up buying more of what has fallen the most (or risen the least).

This is especially useful in bear markets, because it forces you to purchase assets that have dropped in price. Without a rebalancing strategy, you might very well lack the courage to buy after stocks have tumbled, even though this is often the best time to invest.

NEXT: When to Do It

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When to Do It
Now to your question: How often should you rebalance? There are different opinions on this.

In his book The Investor’s Manifesto: Preparing for Prosperity, Armageddon, and Everything in Between, William Bernstein recommends rebalancing a non-taxable account every two to three years.

For taxable accounts, he recommends rebalancing less frequently. Why? Because every time you sell a stock for a capital gain, you’ll pay tax. You’ll also pay a commission every time you buy and sell a stock or exchange-traded fund.

“Rebalance your portfolio approximately once every few years; more than once per year is probably too often. In taxable portfolios, do so even less frequently,” he writes.

While rebalancing sounds easy, it can be a challenge for many investors.

“Do not underestimate the difficulty of adhering to this process, which from time to time takes industrial-grade discipline—particularly when making purchases in the face of potential economic catastrophe.”

Others advocate rebalancing more frequently. In their book The Elements of Investing, Burton Malkiel and Charles Ellis recommend rebalancing once a year—perhaps more often if an asset class rises or falls more than ten percentage points from its target.

“When markets are very volatile, rebalancing can actually increase your rate of return and, at the same time, decrease your risk by reducing the volatility of your portfolio,” they write.

“Investors will also want to consider rebalancing to change their portfolio’s asset mix as they age. For most people, a more and more conservative asset mix that has a deliberately reduced equity component will provide less stress as they approach and enter retirement.”

Not everyone is sold on rebalancing, however.

Indexing pioneer John Bogle, founder of the Vanguard Group, compared the performance of rebalanced against non-rebalanced portfolios (each starting with a 50-50 split of stocks and bonds) over consecutive 25-year periods going back to 1826. The portfolios that were rebalanced annually won 52% of the time—a result so insignificant he considers it “noise.”

In a second study, Bogle examined a diversified index portfolio of US large caps (48%), small caps (16%), international stocks (16%) and bonds (20%) for the 20 years ending in 2006. When the portfolio was rebalanced annually, it returned 9.71%, compared with 9.49% with no rebalancing—a difference he also dismissed as noise.

“My personal conclusion: Rebalancing is a personal choice, not a choice that statistics can validate. There’s certainly nothing the matter with doing it (although I don’t do it myself), but also no reason to slavishly worry about small changes in the equity ratio,” Bogle wrote on his blog.

When fees are involved, the case for rebalancing is even weaker, he said.

“I see no circumstance under which rebalancing through an advisor charging 1% could possibly add value.”

Bottom line: Rebalancing may provide a small performance benefit, and it can help take the emotion out of investing. But it should be done judiciously, particularly in taxable accounts.

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