Most studies of portfolio sustainability make some sort of rebalancing assumption, most typically annually. Further, there are several studies that show a positive effect from rebalancing over time. Rebalancing usually either enhances returns, reduces volatility or it produces a combination of the two. Yet, when it should be done after a large change, many are hesitant. They fear being "early."

Rebalancing has a lot going for it. As soon as the per share price exceeds the price paid by enough, you will have a higher balance than you would if you hadn't bought because you own more shares from the buy. This also means one may recover faster.

Consider a portfolio that targets a 50/50 split between A and B with $100,000 in each. A earns 4% while B loses 20%. The total is $184,000 (A=$104,000 and B=$80,000). To rebalance, $12,000 is moved from A to B so each has $92,000. If A again rises 4%, it will be worth $95,680. The portfolio will be back to $200,000 when B rises 13.39% ($104,320-92000/92,000). If no rebalancing had occurred, A would be worth $108,160 and B would have had to add 14.80% to get the portfolio back to $200,000 (91,840-80,000/80,000).

At a rise of 13.39%, the actual price of B would still be off by 9.29%. This partially explains why so many of our clients were back to pre-Lehman levels long before the Dow or S&P 500. The lower the return on A, the higher the bounce required to make the portfolio whole. If A earned nothing, the bounce needed after a rebalance is 22.22% not the 25% required if no rebalancing had occurred.

Of course, if the market had dropped even lower, rebalancing would have added to the pain. This is what so many fear. Timing is everything as they say. Or is it?
 
In the scenario above, I did not make any indication of the time in between transactions. This could have occurred over a year, or over an hour and it has no bearing on the premise that buying when down, as you would if you rebalanced, can get the portfolio closer to whole faster than if no buy occurs. Despite this, most people have some anxiety about rebalancing after a big drop. The cause of this anxiety is another thing my scenario ignores -- what happens to prices in between the transactions.

Whether the rebalancing transaction occurs at the bottom, early or late makes no difference to the math above, it does present some psychological challenges. Few will want to "throw good money after bad" or "catch a falling knife" as pundits discuss "head fakes,"  "dead cat bounces," "sucker's rallies," short covering or similar things.

Being early may not be as bad as feared. For simplicity, assume A earns nothing but the low price of B ultimately ends up off 40% from its starting point. Rebalancing when we did (after a 20% decline) would result in a lower portfolio value than if no rebalancing occurred. How much lower? In this case, just $2,500 ($157,500 vs. $160,000).

The price of B actually has to drop by 25% from the rebalancing point to be able to say B has dropped a total of 40% from the starting point. The difference between rebalancing and not rebalancing is only the $10,000 buy after the 20% drop in B.

If you didn't rebalance at -20% but did at -40%, that would be a lot better, getting back to whole faster, right? The difference is smaller than many think. B would need to increase by 50% if the only rebalancing happened at -40%. If rebalancing had occurred at the -20% point and again at -40%, B would need to increase by 54%. Either rebalancing choice requires less of a bounce than the 66.67% required with no rebalancing at all.

Real life requires making decisions about an ongoing series of events. I've only isolated one sequence here and I am leaving out a great deal.  I'll have more next month. Until then, does whatever methodology you employ assume rebalancing? Do your clients know that and expect that? Will you be able to execute even in harsh conditions?