Now we'll discuss how rebalancing also keeps your portfolio in line with your target allocation (which should be based upon your risk tolerance and goals).
Consider the case of two investors, Bruce and Mike, who owned the same stock and bond funds in tax-deferred accounts back in early 1997. Both are the same age, have the same goals, share the same risk tolerance and have their desired 60%-40% split between stocks and bonds, respectively.
Emboldened by the stock market's heady gains, Bruce doesn't touch his portfolio. He lets stocks grow into a nearly 70% stake at the end of 1999. Mike, on the other hand, dutifully rebalances his portfolio at the end of each year, shifting money from stocks to bonds to maintain that 60-40 split.
As you might expect, Bruce rode stocks streak to some heady gains in the late 1990s. But he also let the market skew his portfolio far from his target allocations. And just when stocks were most expensive, he had the most money riding on them -- the equivalent of piling heavy bags of money further and further out on a shaky limb.
In the end, Mike averaged an annual gain just under 6.25%, compared with 5.67% for Bruce. Along the way, Bruce had a somewhat bumpier ride. His worst 12-month return was a 13.8% loss in September 2001, compared with a 11.4% fall for Mike & according to our calculations using the Standard & Poor's 500-stock index and intermediate term US Treasury index funds.
Given the modest difference between Bruce and Mike's returns, you might wonder if rebalancing is worth the trouble. If we all could behave like Bruce, coasting can sometimes work out. But not everyone is as steely as Bruce. The "let it ride" approach requires staying the course through volatility. Unlike Bruce, many folks tend to sell out after taking a beating, effectively selling low and later buying higher when things seem better.
Boston fund-tracker Dalbar Inc. recently found that stock-fund investors earned a paltry 2.6% annualized gain from 1984 through 2002, compared with more than 12% for the S&P 500 index. The reason cash consistently flows to funds that have performed well over the past 12 to 18 months, and not to those that have trailed. Rebalancing has the opposite effect of in-the-moment decisions. It allows you to make prudent investment decisions based on your long-term needs rather than momentary emotion.
Finally, there are unexpected consequences to the Bruce method. An investor with a 60%-40% stock-bond mix 25 years ago would've let stocks appreciate to a nearly 90% stake, for example. The result as he or she aged, he or she'd be increasing risk, rather than decreasing it, as most experts recommend.
One big issue we haven't touched yet is Uncle Sam. Of course, it's important to be mindful of tax consequences if you're moving money around " perhaps when you're booking more profits than losses " in a taxable account. However, be warned that managing your investments based upon the potential tax impact alone is a recipe for disaster. The market could easily deliver greater losses than your planned tax savings. Yet, if you rebalance annually, you might be able to use new money to get back in line with your allocation targets, rather than sell shares of funds that have risen highest.
If this sounds like too much work, don't despair. Little noticed but growing in popularity, investment managers and fund companies are making it easier for you to rebalance. Several providers offer management services or funds of funds that allow investors a given allocation that will automatically be rebalanced over time.
So, not only is rebalancing a no-brainer, but you can find someone to do it for you too!
Now we'll discuss how rebalancing also keeps your portfolio in line with your target allocation (which should be based upon your risk tolerance and goals).
