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.)

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).

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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.

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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.

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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.

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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.)

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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.

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