Stumbling During the Rebalancing Act

In designing a portfolio, you should start by deciding on an asset allocation, that is, setting targets for how much of the portfolio will be invested in stocks, bonds, and money market. Next, style your allocations within stocks and bonds. For example, within target stock holdings decide how much will be allocated to large cap value, large cap growth, small cap value, small cap growth, etc. Finally, within each style category decide what specific stocks or funds the large cap value money will be invested in and so on.

Over time asset classes and investment styles perform differently so if your target is to have 60% stocks, 35% bonds, and 5% money market, your portfolio may drift to 70% stocks, 25% bonds, and 5% money market. In this case, rebalancing means selling enough stocks and buying enough bonds to bring back the asset allocation to the target levels.

Readjusting for Success

Rebalancing is needed to control the risk level of the portfolio. When you set the target asset allocations for your portfolio, you actually choose the tradeoff between the portfolio's expected return and risk that is right for you. The higher the stock holding target is, the higher the expected return, but also the higher the risk of the portfolio. If stocks outperform bonds—which is what is expected—the proportion of stocks in your portfolio will become larger than the target you had set and the portfolio will get riskier. Cutting back stock holdings to your target level lowers the risk.

At the style allocation level, rebalancing is recommended based on a phenomenon called reversion to the mean (RTM). RTM is a fancy name for the idea that what goes up, must comes down, and vice versa. So if small cap value outperforms all other style categories for a while, chances are it will underperform in subsequent periods. But we cannot predict for how long and by how much a particular style will outperform others and then for how long.

Rebalancing the various style holdings effectively forces you to take some profit in the style category that has been doing well and reinvest the money in the style category that has been lagging behind expecting that in the future RTM will reverse the relative performance of the two style categories. Psychologically it is not easy to sell a winning category and buy a losing one. But it is the right thing to do.

How Often to Rebalance?

Rebalancing generally involves some transaction costs and often some tax costs as well. If you try to keep your portfolio always very close to the target allocations, you will end up doing a lot of trading and incurring unnecessary costs.

Generally you should use a set band. If your target is 60% stocks and 40% bonds, you probably would not want to do any rebalancing until the stock level goes up to 65% or goes down to 55%. In other words, use a 5% band. You would use a similar approach to rebalance style categories.

It is generally a good idea to check your portfolio's current allocations once or twice a year, but rebalance only if the allocations have moved outside the rebalancing band you have established. More important, you should check the portfolio's allocations after any major market movement— on the upside as well as on the downside— to see if rebalancing is needed. Chandan Sengupta, author of The Only Proven Road to Investment Success (John Wiley; 2001) and Financial Modeling Using Excel and VBA (Wiley; 2004), currently teaches finance at the Fordham University Graduate School of Business and consults with individuals on financial planning and investment management. He welcomes questions or comments at chandansen@aol.com.