Recently, I have tried to put some emphasis on the benefits of rebalancing your portfolio.  I would guess most people agree its important but maybe not understand exactly why.  Most people understand that rebalancing helps maintain our desired risk/reward level.  But a little more subtle, rebalancing also forces us to buy low and sell high — advice everyone can agree with.  Here I will explore this second (and honestly, more important) reason for rebalancing.

One of first things a new investor should do is find their right asset allocation.  This is a tricky thing, with lots of different strategies and theories out there.  I certainly won’t pretend to know which is “correct.”  Without going into details, by investing in various asset classes, you set your risk/reward level and also reduce your overall risk through diversification.

This brings us to the first (and commonly known) advantage of rebalancing.  Over the course of a few years, as different asset classes perform differently, your portfolio mix changes.  This changes your risk/reward level.  By rebalancing, you can restore your desired risk/reward level.

The second advantage of rebalancing requires a little more explanation, though it ultimately boils down to a simple notion: buy low, sell high.  The details are a little more complicated. 

Let me start by emphasizing that we cannot predict the market.  No one knows what the next day will bring.  Hence, the market is random.  But let’s not confuse random with having no structure to the statistics.  For example, say we had an unfair coin.  The coin lands heads 75% of the time, and tails 25% of the time.  Each flip of the coin is random, but we know something about the odds of what may happen.  In addition, that coin may flip tails 10 times in a row (defying the odds!)… but after 1,000,000 flips, about 750,000 of those flips will land heads.  That is to say, things are unpredictable short term (flip to flip) but actually very predictable long term (after an infinite number of flips).  Let’s apply this to asset classes.

Like the unfair coin flipping 10 tails in a row, asset classes can behave very differently from the expected return.  In fact, risk is a measure of how extreme those other-than-expected returns can be.  And, again like the coin, even if year to year the asset class behaves wildly, over the long term we know what to expect.  Here’s how we take advantage of this.

An asset class may perform exceptionally well or exceptionally poorly for a noticeable amount of time, but we know over the long term, the asset class will revert to its expected return.  This means if a class does very well for a few years, those good years will eventually be balanced with bad years.  Simply stated, this over-valued asset class will have a correction.  The price is high.  Of course, the same logic is applied to a poorly performing asset class.  It is under-valued, its price is low, and it will correct!

Rebalancing naturally takes advantage of these over-valued and under-valued trends.  If an asset class is over-valued, it will be a larger piece of your portfolio than you desire.  Rebalancing will have you sell some of your shares when the price is high (the best possible time).  Similarly, if the asset class is under-valued, it will compose a smaller part of your portfolio that it should.  Rebalancing will tell you to buy more shares of this asset class when the price is low.  Perfect!

This might all sound pretty easy — buy low, sell high.  But actually, it might be harder psychologically than you think.  This is because rebalancing forces you buy losers and sell winners!  How excited would you be to buy a bunch of shares in a fund that has done horribly for a number of years?  Its actually counter-intuitive!

Assuming you buy the monetary argument for rebalancing, the next logical question is how often?  Is there some periodicity to these trends?  I would assume this is pretty hard to predict (how long til the housing bubble bursts again??), but William Bernstein of The Four Pillars recommends rebalancing every 2-3 years.  He admits this question is pretty hard to answer.  He also mentions that rebalancing gets you about 0.5% higher returns.

In conclusion, it is important to recognize that asset rebalancing isn’t only about keeping your risk/return in check.  It will actually get your portfolio a higher return!