If you haven’t rebalanced lately you may be exposing yourself to unwanted risk and missing out on better returns.
Why would now be a good time for rebalancing? Year-to-date gains in the S&P 500 and other broad U.S. stock (equity) indices are as high as 18% and above in just the first six and a half months of this year. At the same time, U.S. investment grade bonds (the Barclays U.S. Aggregate Bond Index) are down 2% over the same period. A portfolio tracking those indices with a 60% stock/40% bond allocation at the beginning of the year would now be allocated 65% equity/35% bond. That’s a 30% spread between stock and bond allocation up from 20% before. The portfolio is now riskier because of the higher stock allocation, and is overweighting the asset class that has performed best recently.
If stocks continue to outperform bonds this year, the portfolio would do well but would become even more heavily weighted in stocks. If U.S. stock markets were to fall at the end of this year, the rebalanced portfolio would lose a greater percentage of its total value than it would have if the same percentage drop in the stock market had occurred at the beginning of the year. By rebalancing portfolios on a regular schedule, you can (1) improve risk management by maintaining a consistent level of portfolio risk over time, and (2) take advantage of extra returns that can be generated by consistently selling some assets that have gone up in value and buying some of those that have gone down.
Diversification or Rebalancing Returns
These extra returns are called diversification returns, and in a simple 50/50 stock/bond portfolio rebalanced annually from 2000-2009, the diversification return was more than 1.1% annually, about 25% of the total returns of the portfolio. The name is a bit misleading, however, because these extra returns would not exist in a similar diversified portfolio without regular rebalancing. (Scott 42-44) Rather than just sit back and let the winds of the markets take your portfolio where they may, it can pay to put your paddle in the water and stroke sometimes.
Scott, Willenbrock. “Diversification Return, Portfolio Rebalancing, and the Commodity Return Puzzle.”Financial Analysts Journal. 67.4 (2011): 42-49. Print.