When markets are relatively calm, rebalancing is talked about as a prudent action after markets rise or fall. Now, when the bear is growling, questions arise. New and experienced advisors alike seem puzzled about rebalancing when the economy, financial markets and life in general seem anything but in balance. 

From what I can see in the literature and what I have experienced personally over the past 30 years is that rebalancing provides one sure benefit and two possible benefits. Rebalancing definitely permits long-term strategic investors to control their exposure to risks. It may provide return enhancements and it may help take emotion out of decision making.  

Risk Management
Rebalancing keeps a portfolio’s structure in line with its targeted mix of investments. Staying aligned with the target is important because good financial planning establishes the target based on client goals. Straying too far from targets can be costly and potentially cause a client to fall short of their goals. 

For this discussion, let's say a $200,000 portfolio should hold half its assets in “A”, a fairly stable basket of high-quality fixed-income securities and half in “B”, broadly diversified stocks. A earns 4% while B loses 20%. The total is $184,000 (A=$104,000 and B=$80,000), down 8% with a 57% A to 43% B mix. 

It is overexposed to the risks and potential return of A and underexposed to the risks and potential return of B. To rebalance, $12,000 of A is sold to buy $12,000 of B, leaving $92,000 in each. The portfolio is back to 50/50 and the desired risk exposures are maintained. 

Returns Enhancement
Several studies show that returns can be enhanced through rebalancing (Daryanani, Lee, Blanchett). These benefits do not appear in all periods but buying when prices decline is a feature of most good periods. 

Back to our example. Without rebalancing and assuming A again rises 4%, A would be worth $108,160 and B would have had to increase to $91,840, or 14.8% for the portfolio to reach the original $200,000. 

Because we sold $12,000 of A to rebalance, another 4% will only make it worth $95,680. Therefore, B must rise to $104,320 to put the portfolio back to $200,000. Because we bought $12,000 more of B, it only needs to rise 13.39% ($104,320 minus 92,000 divided by 92,000).  

By rebalancing, the portfolio recovers faster. In fact, at a rise of 13.39%, the actual price of B would still be off by 9.29% from its starting point. The portfolio is whole, yet the offending holding is barely halfway recovered. 

Taking Some Emotion Out Of Decision-Making
In our scenario, we made no mention of the amount of time or what happened between transactions. B could have gone far lower or higher or just muddled around. The math holds and rebalancing accelerates portfolio recovery no matter if the recovery is quick or not or whether it occurred before, at, or after a bottom.

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