Investors have learned the importance ofhaving a well-diversified portfolio. Whatthey may not have learned is the importanceof maintaining that diversificationthrough periodic rebalancing. The diversification lesson is pretty clear. Investorstook it on the chin when they over-concentratedon tech stocks or their employer'sstocks while ignoring bonds, cash, andother assets. It's not simply a matter ofdiversifying your portfolio, though. Youneed to maintain that diversificationthrough periodic rebalancing; otherwise,the market will "rebalance" it for you.
SHIFT INVESTING GEARS
Consider the following numbers fromthe Schwab Center for Investment Research.A portfolio was invested 60% inthe S&P 500 and 40% in Lehman Brothersaggregate bond index at the start of 1996.Four years later, because of the annualdouble-digit run-up in large cap stocks, theallocation for the portfolio, assuming norebalancing, would have shifted to 75%for stocks and only 25% for bonds.
Clearly, leaving the portfolio alone wasgreat for buy-and-hold investors duringthe bull market. Investors who rebalancedduring that period to maintain the 60/40allocation would not have done as well,according to Schwab—until the marketwent south. As it turns out, investors whorebalanced periodically from 1996 to 2001would have fared better than investorswho had left their portfolio as is.
RETHINK YOUR STRATEGY
The challenge for rebalancing is thatthe investor must do something that goesagainst their grain. During bull markets,rebalancing forces them to sell off somewinners, or at least quit buying them, tobuy lagging alternative assets. But investorsrecognize that this forces them touse the smart strategy of selling high andbuying low. Rebalancing is a tougher psychologicalconcept during bear markets;investors are selling, or not buying, better-performingassets so they can buy losers.
To see the benefit, let's go back to theSchwab example. With the decimatedstock market, large cap stocks probablymake up less than the original 60% allocatedand bonds probably make up morethan 40%, particularly in cases where investorsdumped stocks for bonds. Observerscaution that this raises a new risk.
Falling interest rates over the past 2years are what primarily have been boostingreturns for bonds and bond mutualfunds. (Bond prices and yields move inopposite directions.) But with interestrates at record lows, they are not likely todrop much more, and in time will almostcertainly rise. Consequently, many investmentexperts worry that investors areloading up on bonds at a potentially badtime—just as investors were loading up onstocks at the other end of the cycle.
Rebalancing to the investor's original60/40 allocation would reduce the impactof a future decline in the bond market andkeep the investor in stocks during a timewhen they might rebound. That's howrebalancing both reduces an investor'srisk and, over time, produces superioraverage returns in volatile markets.
So what's the best way to rebalance?Start with a diversified portfolio and adefinite plan that states what portion ofyour portfolio you want invested in eachinvestment category based on yourgoals, financial circumstances, and tolerancefor investment risk. For example,you might start with 55% stocks, 30%bonds, 10% real estate, and 5% cash.
The next decision is how to maintainthis mix through rebalancing. Some advisorsrecommend rebalancing once a yearif the portfolio needs it. Another commonmethod is to readjust whenever anygiven category exceeds its allocation by acertain percentage, such as 5% or 10%.Keep in mind this readjustment caninclude subcategories, like the percentageyou have in growth vs value stocks.
To rebalance, you might sell assets inthe over-represented categories and usethe proceeds to buy under-representedassets. But this can present a tax-cost problemif you're dealing with taxable assets.Another method is to return your portfolioto its original allocation.
This column is produced by the Financial
Planning Association (www.fpanet.org), the
membership organization for the financial