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Portfolio Rebalancing: Diversification, Risk Control and Withdrawals

by Charles Rotblut, CFA

Portfolio Rebalancing: Diversification, Risk Control
and Withdrawals Splash image

Rebalancing reduces a portfolio’s risk by maintaining the benefits of diversification, taking advantage of lower valuations and providing an alternative to panic in the midst of a bear market.

It can also increase your overall net worth during periods of turbulent market conditions. These benefits exist regardless of whether you take withdrawals or not.

Given the benefits, rebalancing should be a commonly touted investment strategy. Unfortunately, too often it is an overlooked sibling in the family of investment approaches. This may partially explain why I always get questions whenever I speak about rebalancing. In this article, I explain what rebalancing is, show you examples of how it impacts performance and discuss two alternatives.

Rebalancing and Diversification: Two Close Siblings

Investors constantly hear about the importance of diversification. Including a mix of assets in your portfolio can increase return and reduce risk. Diversification works because different assets, and even different types of investments within the same asset class, exhibit unique return characteristics. One example: Large-cap stocks move independently of bonds over the long term. Similarly, small-cap stocks do not always move in the same direction or exhibit the same magnitude of price change as large-cap stocks do.

I like diversification for another reason: The future is always uncertain. No one can accurately predict which asset class will perform the best over the next five or 10 years. If you diversify, however, you increase your odds of owning the right asset class at the right time.

Yet, as powerful of a concept as diversification is, it loses its effectiveness if a portfolio is not rebalanced on a regular basis. Why? Rebalancing brings your portfolio back to your allocation targets. Rebalancing is the process of shifting your portfolio dollars out of asset classes that are overweighted and into asset classes that are underweighted, according to your personal goals and tolerance for risk.

Let me give you a simple example to explain how rebalancing works. Say a portfolio is evenly split between large-cap stocks and long-term Treasury bonds (a 50% allocation to each asset class). After one year, volatile market conditions send stock prices lower and bond prices higher. As a result, the portfolio’s allocation shifts from 50% stocks and 50% bonds to 44% stocks and 56% bonds. Rebalancing would move 6% of the portfolio’s dollars out of bonds (lowering the allocation from 56% to 50%) and into stocks (raising the allocation from 44% to 50%), returning the portfolio to its target allocations.

A Hedge Against Volatility and Emotions

The reason why rebalancing is so important is that without it the market determines your portfolio’s allocation. This means significantly more volatility and significantly less diversification.

Morningstar’s Ibbotson Associates ran the historical numbers of a 50% stock/50% bond portfolio to see what would happen if the portfolio were not rebalanced on an annual basis. They found that, given enough time, the allocation shifted to 96.7% stocks and 3.3% bonds. Worse yet, the portfolio became nearly 40% more volatile than it would have been if the portfolio had been rebalanced on an annual basis.

Even though the study was conducted over a very long period (1926 to 2010), the lesson is clear: Diversification will have only limited benefit if an investor does not rebalance on a regular basis. Rather, risk will increase, even though a big reason for diversifying is to reduce risk.

What is not factored into the study is human emotions. Even though investors are told to buy low and sell high, it is emotionally easier to sell low and buy high. When market conditions are turbulent, the temptation is to limit losses by selling the asset with the falling price. When market conditions are good, the temptation is to hold onto the winning assets in hopes of realizing even bigger profits.

Rebalancing forces you to lock in profits when others are being greedy, and to buy when others are fearful—a strategy that the legendary investor Warren Buffett recommends. Rather than succumbing to your emotions, rebalancing gives you a plan for dealing with market turbulence. Rebalancing can also serve as a reminder that investing is a long-term process, regardless of how short-term-focused everyone else’s thought process becomes. And when conditions change, you are better positioned to take advantage of the rebound in prices if your portfolio is in balance.

How to Rebalance

There are several ways to rebalance a portfolio. As I discuss a few of the key strategies, keep in mind that it is more important that you regularly rebalance than how you do it.

The most straightforward strategy is to adjust your holdings back to your target allocation once a year (e.g., on the first trading day of January). This means going through each of the major investment categories that make up your portfolio (large-cap stocks, small-cap stocks, bonds, etc.) and shifting portfolio dollars so that each category is back to the target level that you set for it. This method gives you the simplicity of knowing that if large-cap stocks should comprise 20% of your portfolio, but currently comprise just 18%, you need to shift 2% of your portfolio’s value into large-cap stocks.

A strategy that can reduce costs is to rebalance only when your allocations are off target by a magnitude of 5% or more. This is what Francis M. Kinniry Jr., Colleen M. Jaconetti and Yan Zilbering suggested in an article we published last year (“Best Practices for Portfolio Rebalancing,” May 2011 AAII Journal; available at AAII.com.) This strategy strikes a balance between risk reduction and cost control. It will result in fewer transactions over the long term. This is the strategy I personally follow.

A third strategy is to use withdrawals to rebalance. If you are a retiree, you could pull money out of those asset classes that are most overweighted in the portfolio to fund your required minimum distributions (RMDs) from traditional IRAs and other withdrawals. By doing so, you would leave the underweighted asset classes unchanged. Money is not moved around in the portfolio, but rather withdrawals are more targeted. This strategy also makes dual use of withdrawals, which again can limit transaction costs.

We use a fourth strategy for managing the Model Shadow Stock Portfolio, the Stock Superstars Report portfolio and the AAII Dividend Investing portfolio. We calculate the average position size for each stock and use that as the guide for determining how much to spend on a new addition to the portfolio. This works well for rebalancing within a portfolio composed of a single asset class, but it does not work well for a broader portfolio comprised of different assets with varying target allocations. However, you could use this method to rebalance within a specific asset class or investment category, while using one of the previous three strategies to rebalance the entire portfolio. (I personally combine this with the broader 5% rebalancing strategy.)

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Rebalancing and Returns

To show you how rebalancing has impacted a portfolio over the past two decades, I created a hypothetical $100,000 portfolio based on AAII’s moderate asset allocation model, one of three allocation models we track on our website at www.aaii.com/asset-allocation. As shown in Figure 1, the moderate asset allocation model uses a 70% allocation to stocks that are a mix of domestic and international and a 30% allocation to bonds.

To replicate the portfolio, I used Vanguard mutual funds to limit the impact of active management and expenses. Specifically, the target portfolio allocation was 20% in the Vanguard 500 Index fund (VFINX), 20% in the Vanguard Mid-Cap Index fund (VIMSX), 10% in the Vanguard Small-Cap Index fund (NAESX), 20% in the Vanguard Total International Stock Index fund (VGTSX), which invests in both developed and emerging market countries, and 30% in the Vanguard Total Bond Market Index fund (VBMFX).

Though exchange-traded funds (ETFs) could have been used, I chose mutual funds because of their longer history.

The study was started at the beginning of 1988 and ran to the end of 2011. I chose 1988 because that was the first year enough index funds were available to conduct the study. A 20% allocation to Vanguard International Value Investor (VTRIX), an actively managed fund, was used through the end of 1996, when VGTSX was launched. A 30% allocation to the Vanguard Extended Market Index fund (VEXMX) was used from 1988 until 1998, when VIMSX became available. At the start of 1999, the VEXMX allocation was split between VIMSX (two-thirds) and NAESX (one-third) to achieve the desired 20% mid-cap and 10% small-cap allocation.

I first ran the numbers assuming an annual withdrawal rate of 4%. This is a rule-of-thumb percentage suggested by many financial advisers as the optimal amount to maximize withdrawals without draining a portfolio before death. My calculations assume all withdrawals are made at the end of the year.

Table 1 shows a portfolio that was never rebalanced. The only changes made to the allocation were when new index funds became available, and even then the entire portfolio was not rebalanced.

Table 2 shows a rebalanced portfolio. I first made the withdrawals and then checked the allocations to see how close to the target allocations they were. Rebalancing was only performed when at least one fund deviated from its target allocation by a margin of 5% or greater. When this occurred, the entire portfolio was rebalanced back to the targeted allocations.

Table 3 shows how the allocations changed over time for the rebalanced portfolio. The highlighted figures identify points when a particular fund prompted the entire portfolio to be rebalanced. As you can see, the number of rebalancing events increased over the past decade in response to the market’s higher level of volatility.

Annual withdrawals equaling 4% of the year-end portfolio value were taken evenly from each fund.
Year Vanguard
500 Index
(VFINX)
Vanguard
Ext Mkt
Index
(VEXMX)
Vanguard
Mid-Cap
Index
(VIMSX)
Vanguard
Small-Cap
Index
(NAESX)
Vanguard
Int’l
Value
(VTRIX)
Vanguard
Total Int’l
Stock Idx
(VGTSX)
Vanguard
Total
Bond Idx
(VBMFX)
 
 
Total
Portfolio
Starting $20,000 $30,000 $20,000 $30,000 $100,000
1988 23,244 35,924 23,756 32,205 115,129
1989 29,021 43,152 28,475 35,289 135,937
1990 26,743 35,923 23,791 36,865 123,322
1991 33,219 49,207 24,804 41,066 148,295
1992 34,091 53,673 21,287 42,409 151,460
1993 35,798 59,716 25,802 44,853 166,169
1994 34,539 57,031 25,409 42,042 159,021
1995 45,289 74,178 26,116 47,806 193,388
1996 53,274 84,992 26,653 47,515 212,435
1997 68,127 104,983 24,339 49,675 247,124
1998 84,472 111,075 25,280 51,254 272,081
1999 98,976 83,718 44,028 29,308 48,164 304,196
2000 87,796 95,996 40,486 22,678 50,939 297,896
2001 75,146 93,145 39,284 16,205 52,650 276,431
2002 56,780 77,650 29,650 11,883 54,604 230,568
2003 70,592 101,687 40,493 14,088 54,854 281,714
2004 75,678 119,671 45,848 14,300 54,831 310,328
2005 76,686 133,514 46,558 13,658 53,605 324,021
2006 85,682 148,724 50,849 14,013 53,191 352,459
2007 87,329 154,689 48,585 12,931 53,857 357,390
2008 53,199 88,328 29,232 5,630 53,573 229,963
2009 64,965 121,273 37,286 5,182 54,801 283,507
2010 72,045 149,303 44,725 3,238 55,906 325,217
2011 70,811 143,606 40,944 544 57,334 313,239
Ending
Value
$67,679

$140,474
$37,812
$544
$54,201

$300,709
Ending
Allocation
22.50%
46.70%
12.60%
0.20%
18.00%


 
Total Return (withdrawal-adjusted price appreciation) 200.70%
Standard Deviation 13.90%
Annualized Return (post-withdrawals) 4.70%
Total Withdrawal Amount $232,452
Largest Annual Loss (2008; loss calculated before withdrawals for the year were taken) -35.70%

The annualized post-withdrawal return is 4.7% for the non-rebalanced portfolio and 4.8% for the rebalanced portfolio. (If these numbers sound low, keep in mind that they reflect the growth in the portfolios after cash was withdrawn each year. I calculated returns on this basis to show how the actual value of each portfolio was impacted.) Not rebalancing gave you slightly larger withdrawals, averaging about $150 more per year. The rebalanced portfolio was worth approximately $4,000 more at the end of the period, however. More importantly, it was 11% less volatile and it had a 17% smaller relative maximum loss than the non-rebalanced portfolio. These differences may have made the difference between panicking during the last two bear markets—thereby locking in big losses—and staying with a long-term strategy.

Annual withdrawals equaling 4% of the year-end portfolio value were taken evenly from each fund.
The portfolio was rebalanced only when the allocation to one or more funds was off target by five percentage points or more.
Year Vanguard
500 Index
(VFINX)
Vanguard
Ext Mkt
Index
(VEXMX)
Vanguard
Mid-Cap
Index
(VIMSX)
Vanguard
Small-Cap
Index
(NAESX)
Vanguard
Int’l
Value
(VTRIX)
Vanguard
Total Int’l
Stock Idx
(VGTSX)
Vanguard
Total
Bond Idx
(VBMFX)
 
 
Total
Portfolio
Starting $20,000 $30,000 $20,000 $30,000 $100,000
1988 23,244 35,924 23,756 32,205 115,129
1989 29,021 43,152 28,475 35,289 135,937
1990 26,743 35,923 23,791 36,865 123,322
1991 33,219 49,207 24,804 41,066 148,295
1992 34,091 53,673 21,287 42,409 151,460
1993 31,956 49,941 37,948 47,843 167,689
1994 30,637 47,413 38,177 44,938 161,165
1995 39,895 61,281 40,093 51,203 192,472
1996 46,658 69,830 42,068 51,043 209,599
1997 53,600 76,474 39,931 66,063 236,068
1998 65,924 80,304 43,433 69,168 258,829
1999 60,166 57,595 30,290 64,563 73,976 286,590
2000 52,630 65,310 27,251 52,548 79,848 277,587
2001 44,350 62,775 25,806 40,185 84,172 257,287
2002 32,924 51,847 18,993 32,376 88,896 225,036
2003 55,521 57,959 31,461 60,637 67,383 272,960
2004 58,037 63,075 31,418 63,329 81,946 297,804
2005 58,309 69,148 31,173 70,436 81,473 310,539
2006 64,556 75,727 33,181 86,052 82,361 341,877
2007 69,178 69,593 33,200 75,829 105,274 353,074
2008 41,790 38,843 19,419 40,809 107,623 248,484
2009 60,347 66,896 32,470 65,231 75,807 300,751
2010 66,580 80,910 38,398 69,811 78,113 333,812
2011 65,354 62,740 31,149 54,760 103,406 317,409
Ending
Value
$62,815

$60,200
$28,609
$52,221
$100,867

$304,712
Ending
Allocation
20.60%
19.80%
9.40%
17.10%
33.10%


 
Total Return (withdrawal-adjusted price appreciation) 204.70%
Standard Deviation 12.40%
Annualized Return (post-withdrawals) 4.80%
Total Withdrawal Amount $228,927
Largest Annual Loss (2008; loss calculated before withdrawals for the year were taken) -29.60%

Another difference was the impact on the portfolio’s allocations. In the non-rebalanced portfolio, exposure to international markets dwindled to essentially zero after withdrawals were factored in. [I adjusted the 2011 calculation so that withdrawals were not taken from Vanguard Total International Stock Index (VGTSX), but were increased from the other funds. Had I not done this the portfolio’s allocation to the fund would have been approximately –$1,950.] The rebalanced portfolio ended 2011 with a 17.1% allocation to international stocks.

Shown below are the percentage portfolio allocations for each year. Highlighted figures are allocations that are five
percentage points or more off target. The entire portfolio was rebalanced during those years.
Year Vanguard
500 Index
(VFINX)
(%)
Vanguard
Ext Mkt
Index
(VEXMX)
(%)
Vanguard
Mid-Cap
Index
(VIMSX)
(%)
Vanguard
Small-Cap
Index
(NAESX)
(%)
Vanguard
Int’l
Value
(VTRIX)
(%)
Vanguard
Total Int’l
Stock Idx
(VGTSX)
(%)
Vanguard
Total
Bond Idx
(VBMFX)
(%)
 
 
Total
Allocation
(%)
Starting 20.0 30.0 20.0 30.0 100
1988 20.0 31.5 20.5 28.1 100
1989 21.2 32.0 20.8 26.0 100
1990 21.5 29.3 19.1 30.1 100
1991 22.3 33.5 16.4 27.8 100
1992 22.4 35.9 13.6 28.1 100
1993 18.8 30.0 22.5 28.7 100
1994 18.8 29.6 23.6 28.0 100
1995 20.5 32.1 20.7 26.7 100
1996 22.1 33.7 19.9 24.3 100
1997 22.6 32.7 16.6 28.1 100
1998 25.5 31.3 20.0 26.8 100
1999 21.0 20.1 10.2 22.6 26.1 100
2000 18.9 23.7 9.4 18.9 29.1 100
2001 17.1 24.6 9.6 15.4 33.2 100
2002 14.4 23.2 8.0 14.2 40.3 100
2003 20.4 21.3 11.2 22.3 24.9 100
2004 19.5 21.2 10.2 21.3 27.8 100
2005 18.7 22.4 9.6 22.8 26.5 100
2006 18.8 22.2 9.3 25.4 24.3 100
2007 19.6 19.7 9.0 21.5 30.2 100
2008 16.7 15.5 7.3 16.3 44.3 100
2009 20.1 22.3 10.4 21.8 25.4 100
2010 19.9 24.4 11.1 21.0 23.5 100
2011 20.6 19.8 9.4 17.1 33.1 100

I also ran the numbers assuming no withdrawals were made. The rebalanced portfolio had an annualized gain of 9.1%, while a similar non-rebalanced portfolio had an annualized return of 8.9%. Again, rebalancing lowered volatility (standard deviation of 12.9% versus 14.4%) and reduced the relative maximum drawdown by 19.2%. (Tables showing the numbers for these two portfolios are posted below.)

Year Vanguard 500 Index (VFINX) Vanguard Ext Mkt Index (VEXMX) Vanguard Mid-Cap Index (VIMSX) Vanguard Small-Cap Index (NAESX) Vanguard Int’l Value (VTRIX) Vanguard Total Int’l Stock Idx (VGTSX) Vanguard Total Bond Idx (VBMFX) Total Portfolio
Starting $20,000 $30,000 $20,000 $30,000 $100,000
1988 $23,244 $35,924 $23,756 $32,205 $115,129
1989 $30,533 $44,580 $29,925 $36,598 $141,637
1990 $29,520 $38,319 $26,256 $39,763 $133,858
1991 $38,440 $54,356 $28,870 $45,827 $167,494
1992 $41,293 $61,132 $26,353 $49,099 $177,876
1993 $45,377 $69,990 $34,389 $53,852 $203,607
1994 $45,912 $68,755 $36,196 $52,420 $203,282
1995 $63,106 $91,992 $39,687 $61,950 $256,735
1996 $77,545 $108,226 $43,743 $64,168 $293,681
1997 $103,282 $137,108 $43,404 $70,225 $354,019
1998 $132,882 $148,561 $50,176 $76,250 $407,869
1999 $160,881 $114,784 $60,366 $65,188 $75,671 $476,889
2000 $146,305 $135,557 $58,757 $55,010 $84,290 $479,919
2001 $128,719 $134,881 $60,579 $43,924 $91,395 $459,497
2002 $100,208 $115,177 $48,450 $37,299 $98,945 $400,078
2003 $128,767 $154,501 $70,556 $52,345 $102,873 $509,042
2004 $142,597 $185,947 $84,595 $63,252 $107,234 $583,625
2005 $149,398 $211,851 $90,824 $73,101 $109,808 $634,982
2006 $172,764 $240,656 $105,043 $92,573 $114,497 $725,533
2007 $182,076 $255,146 $106,257 $106,942 $122,420 $772,842
2008 $114,672 $148,434 $67,930 $59,780 $128,602 $519,418
2009 $145,048 $208,131 $92,465 $81,735 $136,228 $663,608
2010 $166,675 $261,121 $118,097 $90,824 $144,974 $781,691
2011 $169,958 $255,611 $114,790 $77,600 $155,934 $773,894
Ending Portfolio Value $169,958 $255,611 $114,790 $77,600 $155,934 $773,894
Ending Portfolio Allocation 22.0% 33.0% 14.8% 10.0% 20.1% 100.0%
 
Total Return 673.9%
Standard Deviation 14.4%
Annualized Return 8.9%
Largest Annual Loss -2008 -32.8%
The portfolio was rebalanced only when the allocation to one or more funds was off target by five percentage points or more.
Year Vanguard 500 Index (VFINX) Vanguard Ext Mkt Index (VEXMX) Vanguard Mid-Cap Index (VIMSX) Vanguard Small-Cap Index (NAESX) Vanguard Int’l Value (VTRIX) Vanguard Total Int’l Stock Idx (VGTSX) Vanguard Total Bond Idx (VBMFX) Total Portfolio
Starting $20,000 $30,000 $20,000 $30,000 $100,000
1988 $23,244 $35,924 $23,756 $32,205 $115,129
1989 $30,533 $44,580 $29,925 $36,598 $141,637
1990 $29,520 $38,319 $26,256 $39,763 $133,858
1991 $38,440 $54,356 $28,870 $45,827 $167,494
1992 $41,293 $61,132 $26,353 $49,099 $177,876
1993 $39,094 $61,095 $46,424 $58,528 $205,141
1994 $39,555 $60,017 $48,863 $56,972 $205,407
1995 $54,368 $80,302 $53,577 $67,329 $255,575
1996 $66,808 $94,472 $59,051 $69,739 $290,071
1997 $77,269 $110,245 $57,565 $95,236 $340,315
1998 $99,414 $119,453 $66,546 $103,407 $388,822
1999 $94,149 $90,125 $47,398 $101,031 $115,760 $448,463
2000 $85,619 $106,436 $46,135 $85,256 $128,945 $452,391
2001 $75,328 $105,905 $47,565 $68,074 $139,815 $436,687
2002 $58,643 $90,435 $38,042 $57,807 $151,364 $396,289
2003 $101,846 $106,318 $57,711 $111,230 $123,607 $500,712
2004 $110,898 $120,524 $60,034 $121,009 $156,583 $569,048
2005 $116,188 $137,315 $64,454 $139,851 $160,341 $618,149
2006 $134,359 $155,985 $74,545 $177,104 $167,187 $709,181
2007 $149,481 $150,376 $71,738 $163,852 $227,477 $762,924
2008 $94,143 $87,483 $45,862 $91,592 $238,964 $558,044
2009 $141,174 $156,496 $75,960 $152,599 $177,341 $703,570
2010 $162,223 $196,339 $97,016 $169,568 $188,726 $813,873
2011 $165,981 $159,340 $79,108 $139,075 $262,621 $806,125
Ending Portfolio Value $165,981 $159,340 $79,108 $139,075 $262,621 $806,125
Ending Portfolio Allocation 20.6% 19.8% 9.8% 17.3% 32.6% 100.0%
 
Total Return 706.1%
Standard Deviation 12.9%
Annualized Return 9.1%
Largest Annual Loss -2008 -26.9%
Shown below are the percentage portfolio allocations for each year. Highlighted figures are allocations that are five percentage points or more off target. The entire portfolio was rebalanced during those years.
Year Vanguard 500 Index (VFINX) Vanguard Ext Mkt Index (VEXMX) Vanguard Mid-Cap Index (VIMSX) Vanguard Small-Cap Index (NAESX) Vanguard Int’l Value (VTRIX) Vanguard Total Int’l Stock Idx (VGTSX) Vanguard Total Bond Idx (VBMFX) Total Portfolio
Starting 20.0% 30.0% 20.0% 30.0% 100.0%
1988 20.2% 31.2% 20.6% 28.0% 100.0%
1989 21.6% 31.5% 21.1% 25.8% 100.0%
1990 22.1% 28.6% 19.6% 29.7% 100.0%
1991 23.0% 32.5% 17.2% 27.4% 100.0%
1992 22.4% 35.9% 13.6% 28.1% 100.0%
1993 19.1% 29.8% 22.6% 28.5% 100.0%
1994 19.3% 29.2% 23.8% 27.7% 100.0%
1995 21.3% 31.4% 21.0% 26.3% 100.0%
1996 23.0% 32.6% 20.4% 24.0% 100.0%
1997 22.7% 32.4% 16.9% 28.0% 100.0%
1998 25.5% 31.3% 15.2% 26.8% 100.0%
1999 21.0% 20.1% 10.6% 22.5% 25.8% 100.0%
2000 18.9% 23.5% 10.2% 18.8% 28.5% 100.0%
2001 17.2% 24.3% 10.9% 15.6% 32.0% 100.0%
2002 14.4% 23.2% 8.0% 14.2% 40.3% 100.0%
2003 20.4% 21.3% 11.2% 22.3% 24.9% 100.0%
2004 19.5% 21.2% 10.5% 21.3% 27.5% 100.0%
2005 18.8% 22.2% 10.4% 22.6% 25.9% 100.0%
2006 18.8% 22.2% 9.3% 25.4% 24.3% 100.0%
2007 19.6% 19.7% 9.4% 21.5% 29.8% 100.0%
2008 16.7% 15.5% 7.3% 16.3% 44.3% 100.0%
2009 20.1% 22.2% 10.8% 21.7% 25.2% 100.0%
2010 19.9% 24.4% 11.1% 21.0% 23.5% 100.0%
2011 20.6% 19.8% 9.8% 17.3% 32.6% 100.0%

Notes About the Returns

Regardless of whether withdrawals were taken or not, rebalancing resulted in higher ending values. This is partially a function of the market’s volatility over the past decade. Rebalancing improved returns since the start of 2000, in part by causing stocks to be sold in 2006 and purchased in 2002 and 2008, as Table 3 shows. In the late 1990s, however, rebalancing hurt performance.

Why? Rebalancing moves money out of the best-performing assets and shifts it into the worst-performing assets, which is what happened at the end of 1998. During a bull market for the dominant asset class in your portfolio—stocks for most investors—this will hurt performance. Conversely, during bear market periods, rebalancing makes you buy securities in the dominant asset class when their prices have been discounted, boosting returns.

The main purpose of rebalancing is to control risk. Investing involves making constant choices between risk and reward. Most investors want to maximize return as much as possible, while avoiding the pain of downside risk. The more return you seek, however, the more downside risk you will face. Rebalancing neither prevents reward nor eliminates risk; rather, it helps to lessen the blow of downward moves in exchange for giving up some upside return. It can be construed as a middle-of-the-road risk strategy that is applicable to both conservative and aggressive portfolios alike.

I think it is also important to view rebalancing in the context of human behavior. Giving up some upside return by rebalancing will build significantly greater long-term wealth than panicking and selling in the midst of a bear market. On Wall Street, there is no free lunch, but rebalancing can help keep your investment diet healthy.

Alternatives to Rebalancing

If the numbers and rationale presented here don’t convince you that rebalancing is a prudent strategy, there are alternatives.

The first is to let the market decide your portfolio’s allocation. If you are able to leave your portfolio unchanged during periods of strong turbulence or act like a true contrarian and buy when everyone else is selling, you do not need to rebalance. If your investment nerves are less like steel and more like tin, consider rebalancing. This is particularly the case if you sold late in 2008 and waited until well after the bear market ended to get back into stocks.

The second is to accurately time the market on a consistent basis. This eliminates the need to rebalance because you would always be shifting your portfolio to the right asset at the right time. Unfortunately, market timing on a consistent basis is extremely difficult—many would argue impossible. If you think you are the exception and can time the market, review several years of brokerage statements (more than a decade’s worth if possible) to see if it has really been the case.

When to Rebalance

I check my portfolio twice year, at the start of May and the start of November. There are two reasons for this. First, limiting rebalancing to no more than twice a year reduces transaction costs. Secondly, the Stock Trader’s Almanac says the best six-month period for stocks is generally November through April and the worst six-month period is generally May through October. Looking to see if my portfolio needs rebalancing at the start of these two periods gives me the extra advantage of having potential seasonal shifts work in my favor. However, as previously stated, I only rebalance my entire portfolio when my allocations are off target by 5% or more, following Vanguard’s advice. If the allocations are closer to target, I leave my portfolio unchanged.

It really does not matter on what date you rebalance, as long as you check your allocations on a regular basis. January 1 is good a date to rebalance because it is easy to remember and it may be when you make New Year’s resolutions. Regardless of how often you choose to check your allocations (annually or semiannually), pick a date, mark it on your calendar and rebalance when necessary—regardless of how happy or worried you are about the prevailing market conditions.

Other Assets and Investments

Though I used an allocation mix of stocks and bonds, other assets can be, and should be, incorporated when reviewing your portfolio allocation and determining if rebalancing is warranted. This includes, but is not limited to, real estate investment trusts (REITs), precious metals and preferred stock.

You should look beyond mutual funds and consider all of your investments. Exchanged-traded funds and individual stocks and bonds all contribute to your net worth and should be factored into your allocation decisions.

Finally, keep in mind that investing is messy. You may never get your large-cap allocation to exactly 20%, and that is okay. The goal of rebalancing is to keep your overall allocations from straying too far off target, not to stay in a very narrow band. Giving your portfolio allocations a range to fluctuate in (such as 5%), or a period of time to fluctuate over (such as one year) can help you avoid unnecessary transaction costs.

Charles Rotblut, CFA is a vice president at AAII and editor of the AAII Journal. Follow him on Twitter at twitter.com/CharlesRAAII.


Discussion

Roger from KY posted over 2 years ago:

Just curious, how would $100,000 invested in Vanguard Wellington (or some other balanced fund)have compared. Eliminate all the trading and let the fund do the rebalancing


George from VA posted over 2 years ago:

According to data on Schwab web site, Wellington returned 8.4% per year from its inception. If one just assumed it got an average of 8.4% per year for the 24 years that would be $692,951.

Not as much as obtained from the article's analysis, but a whole lot simpler. Avoids transaction hassle, research time, worry, tax complications, etc. Very suitable for a surviving spouse, or other person who wanted a simple plan. After all, if one is not an investing enthusiast, how valuable is the time one doesn't have to spend each month handling research, bookkeeping, transactions, and tax preparation. And an inexperienced person would probably panic and sell in a downturn and sustain unrecoverable losses.

A big source of worry for elderly investors is how will the surviving spouse be able to manage if he/she was not an investing enthusiast before. Paying some advisor 1 or 1.5 percent per year is one answer, but severely cuts into the "assumed 4%" one could take out of the assets each year.

Like in a basketball game, one is always trying to score the most points before the buzzer sounds. Except that in life, one never knows when his personal "Buzzer" will sound and the surviving spouse must make do with the points scored to date.


Joseph from VA posted over 2 years ago:

I posted a comment a few minutes ago but I don't think it went through because by login had timed out. I will try again.

I ran the mumbers using the AAII portfolio and Vanguard's website for Wellington from end of 1996 to end of 2011 (15Yrs).

On $100,000 Wellington gained $143,490 or total return of 43.5% & 6.1% annualized.

On $236,068 AAII portfolio gained $68,644 or total return of 29.1% & 1.72% annualized.

I think I am going to put some more of my wife's IRA funds into Wellington when interest rate start to rise. For now I have most of it in Wellesley.

Wellington has 65% stocks & 33% bond funds & 2% short term reserves.
Wellesley has about 34% stocks & 65% bonds.

Good thinking Roger.

Joe C.


Charles from NY posted over 2 years ago:

Could someone explain more how the 4th re-balancing strategy works? If I have 400 shares of GE, how does that determine how many shares of stock XYZ I should buy??


Charles from IL posted over 2 years ago:

Comparisons with Wellington are not apples to apples, because Wellington primarily invests in U.S., large-cap stocks (in addition to its bond holdings). This said, holding a balanced fund that adheres to an targeted allocation is an alternative to portfolio rebalancing. Look at the fund's allocation target, however, and make sure that it makes sense for your personal situation, however. And if you hold more than one fund, you may still have to rebalance. -Charles Rotblut, AAII


Charles from IL posted over 2 years ago:

Charles-Say you invested $10,000 in 10 stocks. After a year, your position in eight of them is now $11,000 (a 10% gain). The ninth one jumps in price and your position in it is now worth $15,000. The 10th one falls in value and your position is now worth $9,000. You sell stocks nine and 10, freeing up $24,000 in cash in a portfolio now worth $112,000 (Your average position would now be $11,200 per stock ($112,000 / 10). To rebalance, you could either invest $11,200 in each of the two new stocks you purchase. (You could also increase the amount to $12,000 if you would rather not keep any cash in portfolio.) The logic being that you prevent any single stock from occupying too large a position in your portfolio. -Charles Rotblut, AAII


Roy from OH posted over 2 years ago:

On tables 2 and up I could not read the results on the bottom of the tables


Joseph from VA posted over 2 years ago:

I ran the analysis again using the same time frame as AAII (24yrs) from 1997 thru 2011. Wellington produced a total return of 763.8% & annualized return of 9.9%. Ending value of $863,831 or $157,706 more than AAII indexing & rebalancing analysis. As Roger from Kentucky astutely observed that is a lot simpler and a lot less head aches plus expense for my spouse. I might add that year to year up & down swings are a lot less. So when my "Buzzer" sounds(and at 76 it won't be as long as in the past) I think my spouse would be better off or at least no worse than indexing & rebalancing. This may not be apples to apples comparison but I think it is a valid dollar to dollar return comparison.
Not to worry Charles I am not canceling my subscriptions. I still like your ultra small cap portfolio and appreciate your analysis. I would not have the time & resources for that. I am also trying your dividend investing.

Thanks Charles for all you provide us. Keep up the good work.

Joe C.


George from PA posted over 2 years ago:

I absolutely agree with both Diversification as well as re-balancing.

What I cannot buy (for knowledgeable, active investors who are paying attention) is re-balancing blindly via a pre-set formula.

For example, assume you set your formula during the Clonton era (or the Bush). Today the world is very different: During the past 30 years we have been in an era of rising bond prices that is highly unlikely to continue over the next decade.

By ignoring market conditions you would be buying into a value trap (in bonds).

Another item that I object to is the assumption that investors have no control over their emotions and tend to buy high and sell low.

While I cannot say that I always do it right, I HATE to either buy high or sell low. I would no more buy a stock with a P/E of 20 than I would buy a cantelope for $20 -- regardless of how good the cantelope or promising the stock may be...

Sure, I screw it up now and again. But my goal is to get it right more often than I get it wrong.


Lou from South Carolina posted over 2 years ago:

From a risk control point of view, an 80% stock and 20% bond allocation is optimal (using historical returns) because it minimizes risk (see http://www.aaii.com/journal/article/the-real-world-lessons-from-investment-theory). From a rebalancing point of view, a 50%/50% allocation is optimal because it maximizes buying low and selling high, thereby increasing return. This is an interesting trade-off.


Charles from IL posted over 2 years ago:

We ran the numbers on Wellington and have a correction to Joseph's numbers. An $100,000 investment made in Wellington (VWELX) at the very end of 1997 and held through Dec 31, 2011 would be worth $963,849. This is equates to an annualized gain of 9.9% and is $157,723 more than the 5% rebalanced portfolio would have earned, assuming no withdrawals. -Charles Rotblut, AAII


Philip from CO posted over 2 years ago:

I like the idea of rebalance checks in May and November to take advantage of historical trends, but I can't help thinking that an over-balancing strategy for bonds in May and equities in November might produce even stronger returns.


Richard from FL posted over 2 years ago:

During the financial meltdown in 2008 & 2009, the AAii magazine article in the January, 2009 issue ([pages 5 thru 10) stated to stay the course. I followed this advise and did "nothing" and now my portfolio is up over 100% from the 2009 lows thanks to the advice from AAii in 2009!


Richard from FL posted over 2 years ago:

Fairly strict Bogelian asset allocation with infrequent rebalancing has done extremely well by me over the years. That said, we've seen a Money Market Fund "break the buck", and we're told to expect zero short-term interest rates over the next couple years. It appears to this investor that we've lost the "risk-free asset", and replaced it with essentially return-free risk. Without the anchor of the risk-free asset, does classical asset allocation lose its mooring? And finally, is there really such a thing as "tactical" asset allocation? Isn't that just a fancy term for doing what you think is right, when you think it is right to do so?


John from NY posted over 2 years ago:

Mr. Ratliff's pensive article on portfolio rebalancing of one’s adopted asset allocation approach can be augmented by the following four thoughts:
1. As someone ages they should be revising their asset allocation approach and risk tolerance, meaning that any such rebalancing should target the age-based revised asset allocation.
2. Sales of securities can in part be avoided by dynamic rebalancing – using the cash thrown off from distributions and sales based on the asset specific price movements.
3. Sales for rebalancing purposes should be carefully considered as to the tax implications.
4. No matter how good you are at rebalancing, it will not overtake the most valuable financial management exercise – determining your asset allocation approach.


John Hodge from ak posted over 2 years ago:

Am I missing something? Comparing table 5 from this march 2012 article with table 3 from the similar April 2011 article: The 2012 table eliminates the VEIEX and uses a 5% rebalancing threshold.
This causes a 0.6% lower annualized return and a 0.2% increase in std dev. So why do it?




Charles Rotblut from IL posted over 2 years ago:

John, I excluded VEIEX from the 2012 article because the allocation percentage to the fund was too small to sustain annual withdrawals. Eventually, the withdrawals would have caused the balance in that fund to turn negative. -Charles


Zach Tripp from NH posted about 1 year ago:

I did a similar analysis, it can be found here: http://tinyurl.com/9jbwnsr

I am tracking my daughter's 529 plan that I have a 5% re-balance threshold. Have not had a chance to re-balance yet. http://followmy529.com


Richard Abbott from FL posted about 1 year ago:

I also followed the magazine article in the AAII January 2009 edition. I DID NOTHING and my porfolio is up 120% from the lows of 2009. Thanks to the advise in the AAII magazine to "STAY THE COURSE".


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