Why You Should Rebalance Your Portfolio

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Why You Should Rebalance Your Portfolio
by Bryan Olson, CFA, Vice President, Head of Portfolio Consulting, Charles Schwab & Co., Inc.
November 7, 2007

Rebalancing your portfolio—buying or selling assets to restore your portfolio to your original target allocation—is an important step in controlling risk. It is one of those things that sounds logical but in practice can often feel counterintuitive. Rebalancing requires you to sell assets that are performing well and buy assets that are currently out of favor. Try thinking of it this way: You're taking profits from your winners and buying other assets likely poised to rally.

Before talking about rebalancing and its benefits, first you need something to rebalance. The initial step, as always, is picking a strategic asset allocation plan appropriate for your risk profile, investment goals and time horizon.

Don't confuse rebalancing with reallocation.

Rebalancing is adjusting your portfolio through time to keep it in sync with your risk level. For example, say you're a moderate investor with an asset allocation of 60% stocks, 35% bonds and 5% cash. If the outperformance of your stock investments pushed that mix to 80% stocks, you might sell some stocks and buy some bonds to bring those percentages and portfolio risk back in line.
Reallocation is shifting to a new asset allocation that reflects an entirely different risk level. For example, an investor in her 30s may prefer an aggressive asset allocation with 95% stocks. But by the time she retires, she may switch to a moderately conservative approach with only 40% stocks.

Creating an asset allocation and investment plan is a little like planting a garden. Planting the seeds is only the first step of a process that develops over time. A successful garden requires important maintenance (watering, weeding, pruning) in order to achieve the desired results. In the case of investing, rebalancing is a key form of maintenance.

Fighting your worst nature
In rising stock markets, people often take on more risk than they're suited for. We saw this in the late '90s, when large numbers of investors fell in love with stocks and didn't rebalance. So they ended up with a larger percentage of stocks in their portfolios than their risk levels warranted, simply due to market actions alone. Many even added to their already overweighted technology positions by buying more and more, assuming the stellar performance trend would continue indefinitely, often with little thought as to the impact it might have on their portfolios. When the market began a sharp fall in 2000, their investments were pounded—more than they likely expected and more than if had they rebalanced. The same holds true today with the strong performance of small-cap and international stocks since 2002.

Indeed, many times people only realize they've taken on too much risk when they experience the negative effects of that risk—when the market goes down. Then, they scramble to unload, or worse yet, they hold on to their losing positions, desperately hoping their investments will rebound. They finally sell usually after experiencing substantial declines in investment value. For those who added to their stock positions during the rise, they've bought high and sold low—contrary to conventional wisdom.

Rebalancing's effects
The Schwab Center for Financial Research studied a portfolio of 60% stocks and 40% bonds to see what would happen if no rebalancing took place. As the stock market performed well from 1994 to 1999, the portfolio's 60% stock allocation grew to nearly 80%. This portfolio became overweighted in stocks just in time for the 2000 bear market.

Without rebalancing, a portfolio in the 1990s became too aggressive¹

Source: The Schwab Center for Financial Research with data from Ibbotson Associates, Inc.

We also looked at a portfolio with the same mix of 60% stocks and 40% bonds, starting in 2000. This time, the stock market was falling. By 2002, the portfolio's allocation had flipped, consisting of 40% stocks and 60% bonds. And from 2002 to 2006, a 60% stock and 40% bond portfolio with no rebalancing would have shifted to 70% stocks, 30% bonds.

Without rebalancing, a portfolio in the 2000s became too conservative²

Source: The Schwab Center for Financial Research with data from Ibbotson Associates, Inc.

For another example, consider what happened to a style-neutral small-cap stock portfolio created in 2001 with a 50% growth allocation and a 50% value allocation and left untouched until December 2006³. During the market correction that followed the technology bubble's collapse, value stocks performed considerably better than growth stocks. The 50% allocation to small-cap value on January 1, 2001, grew to 65% at the end of 2006. Meanwhile, the 50% allocated to small-cap growth shrank to 35%. Hence, the original style-neutral portfolio took on a heavy value bias, contrary to the original investment objective.

If you don't have a disciplined rebalancing plan, you're letting the market dictate the risk level of your portfolio.

The value of regular rebalancing
Pension plans and foundations that manage hundreds of millions of dollars have learned over time the critical need for regular rebalancing. Most have documented policies for when to rebalance and formal investment committees that meet regularly to evaluate their portfolios' current allocations and to decide whether to rebalance. This is a smart strategy to control risk and avoid poorly timed emotional decisions, which individuals should follow, as well.

A regular rebalancing plan helps instill discipline in your investing process. To show the value of this discipline, we looked at the risk and return of annually rebalanced portfolios versus portfolios that were not rebalanced. In most cases, a rebalanced portfolio had lower risk and similar to slightly higher returns. The chart below shows what happened when we rebalanced a portfolio with a moderate risk profile annually from 1970 through 2006.

Rebalancing lowered risk and increased returns⁴

Source: The Schwab Center for Financial Research with data from Ibbotson Associates, Inc.

This is a good combination, and it's due to the contrarian nature of rebalancing. When you rebalance, you sell some of the asset classes that have performed well and move to asset classes that haven't done so well—in other words, you buy low and sell high. It's like pruning an overgrown garden and planting new seedlings to keep the garden growing the way you want it to.

You can also approach rebalancing in tax-smart ways, like using a tax-deferred account to avoid taxable gains from such sales. If that is not possible, target any new savings for the asset category that has fallen behind. Another option is to receive dividend and capital gain distributions in cash and channel them toward underweight asset classes. These strategies can help you get gradually back up to your target allocations without incurring fees and/or taxes on the sales of your investments.

How often should you rebalance? We recommend taking a look at your portfolio at minimum once a year and thinking about pruning any asset class that's overgrown its target by more than 5%. Depending on portfolio makeup and market movement, you may want to evaluate more frequently while also assessing the quality of your individual investments. Rebalancing is an art rather than a science. Talk to a Schwab consultant if you need help with a rebalancing strategy.

Important Disclosures

1–2 Source: The Schwab Center for Financial Research with data from Ibbotson Associates. The portfolio above is composed of 60% stocks and 40% bonds on December 31, 1993, and is not rebalanced through December 31, 1999. It is rebalanced to 60% stocks and 40% bonds on December 31, 1999 and not rebalanced through December 31, 2002. Asset class allocations are derived from a weighted average of the total monthly returns of indexes representing each asset class. The indexes representing the asset classes are the S&P 500® index (stocks) and the Lehman U.S. Aggregate Bond Index (bonds).

3. Source: The Schwab Center for Financial Research with data from Ibbotson Associates. Style allocations are derived from a weighted average of the total monthly returns of indexes representing each investment style. The indexes representing the small-cap growth and value styles are the Russell 2000 Growth Index and the Russell 2000 Value Index, respectively.

4. Source: The Schwab Center for Financial Research with data provided by Ibbotson Associates, Inc. The standard deviation and average annual return figures for 1970 to 2006 represent a hypothetical asset allocation plan and are not necessarily indicative of how rebalancing would affect an individual's portfolio. Risk is represented by the standard deviation of annual returns for the portfolio. The asset allocation plan is a weighted average of the performance of the indexes used to represent each asset class in the plan and is shown with both annual and no rebalancing; it does not include transaction costs for rebalancing. The moderate allocation is 35% large-cap stocks, 10% small-cap stocks, 15% international stocks, 35% bonds and 5% cash. The indexes representing each asset class are S&P 500® index (large-cap stocks), Russell 2000 Index (small-cap stocks), MSCI EAFE Net of Taxes (international stocks), Lehman Brothers U.S. Aggregate Index (bonds) and Citigroup U.S. three-month Treasury bills (cash). CRSP 6-8 was used for small-cap stocks prior to 1979; Ibbotson Intermediate-Term Government Bond Index was used for bonds prior to 1976; and Ibbotson U.S. 30-day Treasury Bill Index was used for cash prior to 1978.

The information presented does not consider your particular investment objectives or financial situation and does not make personalized recommendations. This information should not be construed as an offer to sell or a solicitation of an offer to buy any security or pursue a specific investment strategy. The investment strategies and the securities shown may not be suitable for you. Examples provided are for illustrative purposes only and are not intended to replicate results a client could expect to attain. Past performance is no indication of future results.

The Schwab Center for Financial Research is a division of Charles Schwab & Co., Inc.

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