Successful Investment Management 101:
Portfolio Rebalancing and Proper Asset Allocation

Rebalancing your portfolio will save your neck…and your heart! “Rebalancing” is clearly one of the most misunderstood concepts for individual investors but should be one of the most widely followed by every single individual investor. After all, institutional investors have been doing it religiously forever and wouldn’t think of ignoring it. This could be why institutions routinely outperform individuals year after year.

Rebalancing is simply the process of realigning the weightings of one's portfolio of assets. For example, if your portfolio's proportion of stock has grown too large for your intended assets weightings and risk tolerance, you might rebalance by selling some stock and putting it into cash or bonds. Sometimes, all it takes is a periodic rebalancing of your portfolio, back to your desired mix of stocks and fixed-income investments, to smooth out the bumps.

Making these adjustments can make all the difference between complete financial success and dismal failure. A study by Brinson, Singer and Beebower determined that the proper asset allocation, the selection of which specific asset classes to invest in and how much, accounted for 91.5% of the success of a portfolio! All other factors, such as market timing, security selection and other factors account for only 8.5%. This is very surprising to most individual investors.

The proper asset allocation depends on not only your financial, but your life’s goals and dreams. When to retire, how much you’ll need, paying for college tuition, getting that sail boat etc, all affects how much risk is needed to take in order to achieve these objectives. If you’re younger with a higher risk tolerance, you’d allocate more to stocks perhaps to more aggressive sectors. As you get closer to retirement, you can not afford the huge gyrations, so you might lessen the aggressive stock holdings.

For instance, over the last half-century, the worst one-year stretch for a portfolio of 60 percent stocks, 30 percent bonds and 10 percent cash was a loss of 24.1 percent. That occurred in the 12 months that ended in September 1974. By comparison, the worst one-year loss for a more conservative mix – 40 percent stocks, 40 percent bonds and 20 percent cash – was just 15.5 percent during the same period. Yet to achieve this lower risk, the switch in asset allocation strategy would have reduced your average annual returns to 8.3 percent from 9.2 percent.

For some investors, that may be too significant a loss of potential returns to consider. So does tactical rebalancing work, rather than permanently reducing your exposure to stocks for the long run? The answer turns out to be yes! Say you started investing at the end of 1984, in a portfolio consisting of 60 percent stocks, 30 percent bonds and 10 percent cash, and never rebalanced this portfolio back to that 60-30-10 ratio. Instead, you did what a surprisingly large percentage of individual investors do: you let the market take your investments for a ride.