Keeping portfolios in perfect balance

One of the giddy holiday traditions at many households during the new year, along with the Lighting of the Candles and the Hanging of the Greens, is the Rebalancing of the Portfolio.

But if your family doesn't gather around the old ledger and joyously rejigger your asset allocation, be of good cheer. It's a tradition that you don't have to observe too closely — in fact, the more often you do it, the less benefit you get.

One of the basic tenets of investing is that your asset allocation is the largest single factor in how much you'll earn over time. For example, suppose you put $10,000 into the Standard & Poor's 500-stock index 30 years ago and reinvested the dividends. Your investment would have grown to about $341,000 by now.

stocks. Over the very long term, stocks tend to make more money than bonds.

But what a ride! Your account would have fallen almost half during the 2000-02 bear market. For many people, those kinds of losses just aren't worth the risk. Adding bonds to your portfolio would have reduced your returns but also smoothed the journey.

Bonds pay regular interest income, which dampens losses from stocks. More important, however, bonds have a low correlation with stocks — that is, bond prices don't move in lockstep with stock prices. That's good.

For example, in October 1987, the S&P 500 lost a mind-melting 21.5%, assuming reinvested dividends. But the Lehman Government Bond index rose 3.9%. Had you put 40% of your money in bonds and 60% in stocks, your loss would have been cut to about 11%.

The problem with asset allocation is that no sooner have you set your allocation, it's out of whack. If you're a Type A personality, this will make your left eye twitch. More important, over time an unbalanced portfolio may give you more risk than you want.

Suppose, for example, you put $4,000 into bonds and $6,000 into stocks 30 years ago, and then forgot about it. By the 1990s, your portfolio would have become so unbalanced that you would have wanted to hide the steak knives. More than 86% of your assets would have been in stocks. You would have lost 35% during the bear market.

But how often should you rebalance? At least for the past few decades, a lighter touch has done the most good. Let's assume, once again, that you started 30 years ago with $4,000 in bonds and $6,000 in stocks. Had you never rebalanced, you would have ended the period with $256,600. How you would have fared if you'd rebalanced:

•Monthly, $254,000.

•Annually, $256,000.

As you can see, rebalancing regularly didn't improve your returns greatly. In fact, the more often you rebalanced, the less you made.

Why? An old adage on Wall Street is "Cut short your losers and let your winners ride." When you rebalance often, you're selling your best-performing investments and shoveling the proceeds into your worst performers.

But rebalancing occasionally can help your returns somewhat. Let's say you decided to rebalance only when your portfolio allocation was out of kilter by 5 percentage points — that is, when stocks were either 65% or 55% of your portfolio.

This doesn't happen often: A portfolio of stocks and bonds is a remarkably self-balancing creature. In 30 years, you would have rebalanced 16 times. But you would have ended the period with $259,000.

Had you set the bar at 7 percentage points, you would have rebalanced 11 times the past 30 years. You would have ended the period with $265,000 — and your portfolio would have been about as volatile as if you rebalanced every year.

Rebalancing as little as possible has two added advantages: It reduces your potential tax bill and your transaction costs, too. And you can use the time you save for more important holiday events, such as the Opening of the Gifts.


Source: USA Today