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Re-Balancing May Be More Important Than You Think

Most investors have some notion that they should be re-balancing their investment portfolio, but few have a strategic approach to doing so, which is unfortunate. Increasing evidence suggests that re-balancing is important to long-term success.

Stepping back a bit, let’s look at what exactly re-balancing is? It is the act of incrementally selling things that went up and buying things that went down (or went up less) in order to move portfolio weights back to their intended levels. There are many re-balancing strategies.

Having studied them intensely, I have my own opinions about how re-balancing should be managed, but 80 percent of the battle is won by doing some periodic re-balancing and remaining disciplined about it. Most people, if given the opportunity to try to time re-balancing, will get it wrong by following herd mentality and selling at the wrong time. Also, it doesn’t need to be done that often. We use sophisticated software to check daily if some type of re-balance makes sense. For those without it, every year or two is enough.

Re-balancing should be done at the asset allocation level as well as at the individual security level. Traditionally, the main goal of re-balancing was to control risk and keep portfolios aligned with investor goals. However, it is now commonly accepted that re-balancing increases risk-adjusted returns, and may even increase absolute returns.

Capital markets tend to be volatile and cyclical. No single investment or style can outperform indefinitely. By re-balancing back to a target weight, overall return will be increased when styles shift. This is tough for many people because trends can last a long time, and selling winners can create adverse tax impact.

The following chart demonstrates how re-balancing can improve return. It is a 10-year growth of a $1 million portfolio with a 50 percent 7-10 Year Treasury bond allocation and a 50 percent S&P 500 Stock Index allocation. The red line is rebalanced back to the target annually.

The rebalanced portfolio grew by over $100,000 more. This is significant. Because re-balancing is most powerful in choppy markets, the results will not always be as dramatic.

And yes, there will be periods when re-balancing mutes return when trends are running. Also, if you believe stocks will outperform in the long run, it is best never to re-balance them down. But for those also concerned with risk and who judge performance over full market cycles, a strategic re-balancing plan makes sense. Please note that before you can have a strategic – plan, you must first have a strategic asset allocation, which I hope you do.

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