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Personal Planning


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.

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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 tolerate.

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 value.

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 rebalancing is.

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 rebalancing?

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 their ranges).

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).

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