It’s considered prudent to rebalance when the markets rise or fall. But that’s what people usually say when markets are calm. 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, rebalancing provides one sure benefit and two possible benefits. It definitely allows long-term strategic investors to control their exposure to risks. It may also improve returns and may help take the emotion out of decisions.

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 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,” a group of broadly diversified stocks. Let’s say “A” earns 4% while “B” loses 20%. What’s left is $184,000 (“A” is now worth $104,000 while “B” is worth $80,000). The portfolio is down 8%, and what’s left is a mix of 57% in investment “A” and 43% in investment “B.”

The portfolio is now 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.

Return Enhancement
Several studies (including the work of researchers Gobind Daryanani, Marlena Lee and David Blanchett) show that a portfolio’s returns can be improved with rebalancing. It’s not something that happens over all time frames, but it has been shown to work when investors buy at a time prices are declining.

Take our portfolio with investments “A” and “B.” Let’s assume that we don’t rebalance, and our fixed-income basket “A” again rises 4%. It’s now worth $108,160. Our basket of stocks, “B,” would have to rise from $80,000 to $91,840, or by 14.8%, for the portfolio to reach the original $200,000.

If we did rebalance, however, that means we sold $12,000 of “A,” meaning 4% growth on $92,000 would leave it worth only $95,680. Therefore, the “B” stock basket must rise to $104,320 to put the portfolio back to $200,000. Because we bought $12,000 more of “B,” it needs to rise only by 13.39% ($104,320 minus $92,000 divided by $92,000).

Because we rebalanced, the portfolio recovers faster. However, after “B” increased 13.39%, if we were to calculate its per share price, it’s still off by 9.29% from its starting point. The portfolio is whole, yet the offending holding is barely halfway recovered.

Taking Emotions Out Of Decisions
In our scenario, we made no mention of the amount of time or what happened between transactions. The “B” investment could have gone far lower or higher or just muddled around. The math holds, and rebalancing accelerates portfolio recovery no matter whether the recovery is quick or whether it occurred before, at or after a bottom.

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