Why Rebalance Your Portfolio?

by Michael on Nov 7, 2012 · 1 comment

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The vast majority of individual investors are aware that you should periodically rebalance your investment portfolio.

While much has been written about rebalancing strategies — when and how to rebalance your portfolio — less attention is typically paid to why you should rebalance.

Or, perhaps more accurately, I should say that when people do think about why they should rebalance, they often focus on the wrong things.

Here’s what I mean…

If you keep your ear to the ground, you’ll undoubtedly hear people talk about how you should “let your winners run” or they’ll say that you don’t want to have everything in stocks (or bonds) because then you won’t be able to rebalance when the market is down (or up, though they usually focus on the down).

On the surface, both of these arguments sound attractive.

Letting your winners run

After all, if you believe the markets consistently exhibit momentum, then perhaps you can capture a bit of added return by waiting to rebalance. Right? Well, maybe. But keep in mind that, in letting your winners run, you’re effectively changing your risk profile.

Let’s say that stock are on a tear and that your 60/40 mix has shifted to 70/30. Should you let your winners run? In doing so, you may well earn higher returns — in fact, that’s exactly what you’d expect due to the higher stock allocation — but you’ll be taking on greater risk at the same time.

Is that an acceptable tradeoff? Perhaps. But if it is, then why aren’t you holding more stocks in the first place?

In the extreme

On a related note, let’s consider the all stock (or bond) argument… There are many good reasons not to go all in on any one asset class, but I would argue that rebalancing (or the inability to do so) is not one of them.

If, for whatever reason, you decide that 100% bonds is right for you*, then the inability to rebalance is a non-issue. You’ve identified your optimal mix, and your goal should be to maintain that. You can’t rebalance, but who cares? You don’t need to. You’ve already locked (your self-defined) perfection.

*Note: I don’t personally think that 100% bonds is right for anyone because you can boost returns and reduce risk by adding a small amount of stocks to that portfolio. But that’s beside the point.

The reason to rebalance

And therein lies the point of rebalancing. You should rebalance your portfolio to minimize tracking error. Presumably, you constructed your portfolio to match you risk tolerance as well as (hopefully) your risk capacity. Assuming so, then your goal should be to maintain that.

Sure, if you “let your winners run” you might achieve higher returns. But you’ll be taking on additional risk. If that’s an acceptable tradeoff then, as I asked above, why aren’t you targeting a more aggressive mix in the first place?

Is this to say that you should rebalance early and often? No, not necessarily. There are many factors to consider, not the least of which are transaction costs and the tax consequences of your actions.

Here’s what I suggest:

Start by sitting down and figuring out your desired asset allocation based on the particulars of your situation. If you’re not comfortable doing this, then consider engaging the services of a trustworthy financial planner to help you do so — but keep in mind that this isn’t rocket science.

Next, come up with well-defined rules for when to rebalance. For example, use a set timeframe (e.g., annually), tolerance bands (e.g., whenever your 60/40 portfolio gets below 55/45 or above 65/35) or some combination thereof.

And finally… Put your plan into action.

That’s it. Don’t over think it and don’t try to beat the system.


1 MoneySmartGuides November 7, 2012 at 5:55 pm

This is the same way that I explain it to others as well. You decided you can handle the risk of a 60/40 portfolio. No rebalancing can make your portfolio become 80/20. While it doesn’t seem like a bad thing, it is because you are taking on more risk than you are comfortable with. If the market tanks, you are going to lose more than you would have if you rebalanced and kept your portfolio at 60/40.

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