Rebalancing: A Simple Way to Boost Returns
By Bob Carlson
Sophisticated and institutional investors do some things the average individual
investor does not do. Not all of these actions are available to individual
investors. But there is one tool of the sophisticated investor that is
available to every investor and easy to use. Yet very few individuals use it. Using
this tool over the long term will increase returns and reduce risk.
The overlooked strategy is portfolio rebalancing.
Most of us have portfolios that are diversified to some extent. A diversified
portfolio holds assets that are less than perfectly correlated with each other.
When one asset appreciates, one or more other assets in the portfolio will hold
their value or decline. An extreme example is a pairing of stocks and
commodities. These tend to move in opposite directions over time.
When a portfolio is created, the asset allocation is selected because in the
past that combination of assets generated a particular level of risk and
return. The return met the investor's goals, and the risk was one he could
As the markets move in different directions over time, the allocation changes.
To take a simple example, suppose a portfolio is invested 60% in an S&P 500
index fund and 40% in a bond index fund. After one year, the S&P 500 has
returned 10%, and the bond index has declined 3%. The portfolio now is 63%
invested in stocks and 37% in bonds. That is not a big move, but it is a change
from the target. The next year the S&P 500 returns 15%, and the bonds return
0%. Now the portfolio is 66% in stocks and 34% in bonds.
The risk and return profile of the portfolio has made a significant change. The
investor is taking on more stock market risk and has less of the stability and
income of bonds. In addition, as the stock market rises over time, it
probably is riskier than it was. There is greater likelihood that stocks are
overvalued and due for a correction or bear market.
Rebalancing is the simple act of periodically bringing a portfolio back to its
original asset allocation. In this example, the investor would sell some of the
stocks and use the proceeds to purchase bonds. That gives the investor the same
risk and return trade off he intended.
The great benefit of rebalancing is that it forces the investor to do what he
should do: Buy low and sell high. You sell the investments that have
appreciated and purchase those that have declined or merely maintained their
Rebalancing is routine for institutional investors, but most individual
investors are never told of the need for rebalancing. Those that know about
rebalancing rarely do it. It takes some discipline to periodically rebalance a
portfolio. In addition, rebalancing is counterintuitive for most investors.
Instead of letting winners run, you are selling them and buying the losers.
That is the smart thing to do, but many investors prefer not to sell a winner
until it has reversed course and do not want to sell a loser until it returns
to the break even point.
Also, while rebalancing works over the long term, it can hurt short run
performance. Investors who rebalanced through the last half of the 1990s did
not look very smart in the short run. They were taking money out of stocks as
equities continued an historic bull market. In the end, we know rebalancing was
the right move. Investors who did not rebalance ultimately wished they had. The
bull market of a lifetime quickly became the bear market of a lifetime. Very
few of the investors who let their equities ride during the bull market were
able to reduce them near the top. A rebalancing program forces the investor to
take some profits.
Here is how a rebalancing program produces benefits over the long term,
according to a study recently published in Financial Planning magazine. A
diversified, five asset portfolio was invested from January 1985 through
December 2004. Suppose over the 20 years it was a simple buy-and-hold portfolio
with no rebalancing. Then, the average annual return was 11.53% and the
standard deviation (volatility) was 13.57%.
But when the portfolio was rebalanced annually the annual return increased to
11.81% while the standard deviation decreased to 10.96%. Rebalancing generated
a higher rate of return with less volatility.
Rebalancing works. The more diversified a portfolio, the more volatile the
assets, and the lower the correlation between assets, the more important
Once a decision is made to rebalance, there are other issues. How often
should a portfolio be rebalanced, and what should the allocation be after
The easiest rebalancing strategy is to execute the strategy according to the
calendar. Many institutional investors rebalance on a daily, weekly, or monthly
basis. They do not want their portfolios to stray very far from the desired
allocation. Individual investors can rebalance according to the calendar but
less frequently. Some advisors recommend a quarterly rebalancing, but for most
individuals annual rebalancing is sufficient.
All calendar-based rebalancing programs, however, have a flaw. The market does
not fluctuate according to a convenient calendar schedule. An annual
rebalancing will work fine for a portfolio that has a few assets, none of which
are very volatile. A portfolio with some volatile assets, such as stocks,
probably should be rebalanced according to market changes instead of the
calendar. Otherwise good rebalancing opportunities will be missed.
A market-based rebalancing system often is called a range, or tolerance,
rebalancing system. When the initial asset allocation is set, the investor also
sets the minimum and maximum that he will allow each asset to reach. For
example, the S&P 500 allocation might be set at 60% with an allowable range of
as low as 57% or as high as 63%. An emerging markets allocation might be 5%
with a range of 3.5% to 6.5%.
The portfolio allocation is examined on a regular basis. When an asset exceeds
its range, appropriate action is taken. If an asset drops below its minimum,
then money is taken from the assets that have appreciated the most (even if
they still are within their ranges) and that money is added to the asset that
is light. Or when an asset exceeds its maximum, it is reduced and the money
added to those that are farthest below their targets (even if they are within
Some advisors recommend bringing an asset back to the limit of its range, but I
believe it is best to bring the allocation all the way to its target. Otherwise,
rebalancing would occur too often for most individuals.
When setting a rebalancing range, I suggest setting either a very narrow range
or a broad range. The Financial Planning study shows that a middle ground
produces the least favorable results. The narrow range does a better job of
controlling risk, while the broad range increases long-term returns while
introducing more risk to the portfolio.
There are costs to rebalancing, in addition to your time. Assets held in a
taxable account will incur taxes when winners are sold. In addition, there
might be trading fees, redemption fees, or other costs with the transactions.
While the costs are unpleasant, the studies show that over the long term the
benefits of rebalancing exceed the costs.
In the end, the specifics of a rebalancing strategy do not matter as much as
having a rebalancing policy and consistently following it. You will sell high
and buy low. That will reduce risk and increase returns over the long term.
Bob Carlson is editor of Retirement Watch, a monthly newsletter covering all
the financial aspects of retirement and retirement planning (www.RetirementWatch.com;
800-552-1152). He also is author of The New Rules of Retirement (Wiley, 2004).