Financial Planning Blog

If you manage your personal 401K account, IRA, or other investment portfolio, you've probably heard that you should rebalance your investments regularly. However, you may not really understand what rebalancing is, or why it is important. And, if you don't understand these basics, it's unlikely you are going to follow through on this important bit of investment portfolio maintenance.

What do we mean by rebalancing a portfolio?

Rebalancing is the systematic process of selling some assets and buying others in order to restore your investment portfolio to your target asset allocation. Of course, this assumes you have gone through some process to decide on a strategic asset allocation that makes sense for your personal financial situation. There are numerous books and web resources to help you with the task of developing an asset allocation plan. However, if the DIY route doesn't sound right for you, this is an area to employ a competent financial advisor who will walk you through the process. If you work with a fee-only financial planner, you can be assured that their advice is not skewed by sales commissions and other incentives to push particular financial products that may not be in your best interest.

Over time, an investment portfolio will naturally move away from its original, target allocation. This is because each of the different investments will go up and down at different rates. Every so often you need to go in sell some investments that have grown to be a larger percentage of the total you're your plan calls for. You use the proceeds of these sales to buy more of the investment assets that have fallen below their target percentage.

Why is rebalancing your portfolio important?

The number one reason to rebalance is to control the level of risk that your portfolio is exposed to. For example, you and your advisor decide that a 50% stock and 50% bond allocation will likely deliver adequate returns to meet your objectives, with an expected level of volatility or risk that you are comfortable with. Imagine that over the next two years, stocks rise at 20%/year and bonds rise at 5%/year. Now your portfolio consists of 57% stock and only 43% bonds. You care about this because your portfolio has become riskier than you decided was appropriate two years earlier. The same thing can happen in reverse, when bonds do well and stocks decline in value, a portfolio can become too conservative. A portfolio that is too conservative is less likely to produce adequate returns to meet an investor's objectives. Rebalancing is about maintaining the risk/return balance that is appropriate for your situation.

A second reason to rebalance your portfolio is that the process is likely (although not guaranteed) to marginally increase your long-term investment returns. It does this by causing the investor to sell assets that have been increasing in value in order to buy assets that have been decreasing (or not increasing as fast) in value. You know you should "buy low, sell high", but it's not as easy as it sounds. It goes against our nature to sell some of the mutual funds that have been doing so well, and turn around and invest more in those currently dragging down our portfolio. This discipline, imposed by the reallocation process, can pay off with marginally higher returns over the long run. Jason Zweig of the Wall Street Journal discussed this topic earlier this year in his "The Intelligent Investor" column.

In Part 2, we'll look at a quick illustration of how rebalancing not only maintains your target risk level, but adds to your returns. In the meantime, this article from Charles Schwab has some good illustrations from their research of the value of rebalancing.