Rebalancing: Hard to do but worth it

Much research has supported the benefits of regularly rebalancing a portfolio. It suggests that an investor should start with a target asset allocation and then regularly sell or buy individual holdings in order to keep that allocation steady. For instance, suppose the investor starts with 50 percent in stocks and 50 percent in bonds. A year later the stock market has fallen, and the investor now has 40 percent in stocks and 60 percent in bonds. To rebalance, the investor should sell enough bonds and buy enough stocks to restore the original 50/50 balance. This forces the investor to sell something that has increased in value and to buy something that is now at a more reasonable price.

“Anecdotal evidence suggests that most investors do not rebalance their portfolios,” says Research Affiliates, an investment management firm based in Newport Beach, Calif. “Perfectly rational individuals exhibit changing risk aversion that makes it hard for them to rebalance into high-return assets that have had steep price declines,” wrote Jason Hsu, chief investment officer of the firm. He said it is not just individuals who fail to rebalance, “but also sophisticated institutional investors advised by investment consultants and academics who are also prone to the same behavior.” This behavior overlooks research that shows the individual investment asset classes exhibit long-term mean reversion in prices. In simpler terms, periods of outperformance are followed by periods of under-performance, and vice-versa. “So when an asset class falls in price …it’s more likely to experience high subsequent returns,” Hsu wrote. For instance, after extended falls in the Standard & Poor’s 500 Index, subsequent five-year returns have been significantly above average.

Investors should consider rebalancing their portfolio annually at the same time of year. That way they won’t be swayed by short-term market movements. More frequent rebalancing may be counter-productive because assets tend to have momentum when moving in one direction and an investor may end up selling a rising asset too soon to reap the full benefit of its move upwards.