Why Rebalance Your Portfolio?

An important part of the indexing strategy is that you occasionally rebalance your portfolio back to its target asset allocation. I get a lot of questions about rebalancing, so I felt it was time to put together a series of posts about the idea.

For those who are new to the concept, we’ll start with a primer on what rebalancing is. One of the most important decisions investors will ever make is their asset allocation—the percentage of stocks, bonds, cash and other asset classes in their portfolio. For example, a mix of 60% stocks and 40% bonds is common in a balanced portfolio.

The problem is that asset allocations don’t stay constant. As the markets move month by month, your portfolio’s stock-bond mix will change, sometimes dramatically. If you had a 60-40 portfolio in mid-2008, the stock portion fell to about 45% by March 2009. If you were at 60-40 when the market bottomed, then your mix would be close to 80% equities today.

That’s why investors should occasionally adjust their portfolio to get it back to its target. You can do this by adding new money to the underperforming asset classes, or by selling off some of the outperforming funds and using the proceeds to prop up the laggards. In either case, the idea is to “reset” your portfolio to its original asset allocation.

Why rebalance?

One of the benefits of rebalancing is that it encourages you to buy low and sell high, so many people assume that the strategy is designed to boost returns. But that’s not actually the case. Think about it like this: if stocks outperform bonds over the long term—and we wouldn’t invest in stocks if we didn’t expect this—then a portfolio that is never rebalanced will naturally become more and more heavily weighted to equities. So more often than not, rebalancing will mean trimming back stocks and moving that money to the fixed income side. Over the long term, that’s likely to lower returns, not increase them.

If we assume an annualized return of 10% for stocks and 5% for bonds, then a portfolio that starts out with 60% in equities will naturally drift to 80% stocks after 20 years. Most investors do not want their portfolios to get more risky as they age. Rebalancing, then, is primarily about managing risk by keeping your asset allocation more or less consistent. If it does boost returns, that’s simply a bonus.

Another benefit of systematic rebalancing is that it helps investors control their behaviour. Whenever you add money to your portfolio, you need to make a decision about where to allocate those new funds. If you’re like most investors who simply follow their emotions, you’ll likely add the money to whatever asset class is hot. (How many people are enthusiastically adding to the bond side of their portfolios these days?) However, this is simply performance chasing, and over the long term, it’s disastrous. A disciplined rebalancing schedule—preferably written down in an investment policy statement—helps you avoid this trap and stay on course.

So how frequently should you rebalance your portfolio? There is no simple answer, but in my next post, I’ll look at some of the options.

H&R Block At Home software winners

Congratulations to the five winners of a free copy of H&R Block’s At Home tax preparation software: Amy, Alex, Kevin, G Sharma and James. Winners will be notified by email.

Thanks to everyone who entered the draw, and to H&R Block for supplying the software.