Personal Finance

Why Rebalancing Is Important

April 5, 2017
Stay ahead of market swings and keep your long-term investment plan on track by rebalancing your portfolio annually.

Key Points

  • One approach for maintaining a consistent investment strategy with an appropriate level of risk involves periodically rebalancing a diversified portfolio.
  • Rebalancing should not involve attempting to “time the market” by making aggressive bets on which asset classes will perform best over the short term.
  • Instead, making gradual and modest shifts based on a consistent schedule can reduce portfolio volatility and help minimize the emotional aspects of investing.

Taking emotions out of your strategy and building discipline into your approach can help set you up for greater long-term success. By shifting money among various asset classes to adhere to your long-term, diversified allocation targets, you can prevent your risk exposure from drifting higher when markets are performing well and potentially take advantage of stock market declines by investing at more attractive prices. "Rebalancing may seem counterintuitive to some investors," says Judith Ward, CFP®, a senior financial planner with T. Rowe Price. “It’s sometimes difficult emotionally to trim the areas that have been doing well in favor of areas that have been under pressure. However, when you think about the rebalancing process, you’re actually selling high and buying low. It is a way to be more disciplined in your investment approach and minimize the emotional aspects of investing.”

Rebalancing in practice

Consider the performance of a hypothetical portfolio assuming an initial $100,000 investment on December 31, 1996, in a balanced portfolio of 60% equities and 40% U.S. investment-grade bonds. In one scenario, the portfolio is never rebalanced; in the other two scenarios, the portfolio is rebalanced quarterly and annually to maintain the original target allocation. (See “Rebalancing Lowers Risk.”)

REBALANCING LOWERS RISK

Over time, a rebalanced portfolio generally reduced volatility while achieving roughly the same, if not better, returns as a non-rebalanced portfolio.

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Source: T. Rowe Price.

Over longer periods, rebalanced portfolios have achieved similar returns at a lower level of risk as measured by the standard deviation of returns.* And when looking closer at pivotal market events, the annually balanced portfolio helped preserve capital during two major bear markets over the past 20 years. (See "Navigating the Last Two Major Downturns.")

NAVIGATING THE LAST TWO MAJOR DOWNTURNS

These two hypothetical portfolios each started with $100,000 invested on January 1, 1997. One was rebalanced annually to the original allocation over the next 20 years; the other was not rebalanced at all. The rebalanced portfolio declined less in bear markets, was less volatile over the entire 20-year period, and outperformed the non-rebalanced portfolio.

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Source: T. Rowe Price.

Annual reviews

Since a portfolio’s asset mix constantly changes in line with market performance, Ward advises investors to review their asset allocations at least annually and evaluate whether they are comfortable with their overall risk exposure. Rebalancing should not involve making bets on which asset classes will perform best over the short term. Instead, rebalance by making gradual and modest shifts on a consistent schedule.

Keep in mind though, while rebalancing a portfolio in a tax-deferred account such as an IRA or 401(k) has no immediate tax implications, a sale within a taxable account may result in taxable capital gains.  

*Standard deviation is a measure of volatility that indicates the range of possible outcomes for a portfolio—positive or negative—over a given period of time. The higher the standard deviation, the greater the volatility or market risk.

Past performance cannot guarantee future results. All charts and tables are shown for illustrative purposes only. It is not possible to invest directly in an index.

The initial asset allocation for all hypothetical portfolios was composed of 36% large-cap U.S. stocks (Russell 1000 Index), 6% small-cap stocks (Russell 2000 Index), 18% international stocks (MSCI EAFE Index), and 40% U.S. investment-grade bonds (Bloomberg Barclays U.S. Aggregate Bond Index).

MSCI makes no express or implied warranties or representations and shall have no liability whatsoever with respect to any MSCI data contained herein. The MSCI data may not be further redistributed or used as a basis for other indices or any securities or financial products. This report is not approved, reviewed, or produced by MSCI.

Russell Investment Group is the source and owner of the trademarks, service marks, and copyrights related to the Russell indexes. Russell® is a trademark of Russell Investment Group.

Note: Bloomberg Index Services Ltd. Copyright 2017, Bloomberg Index Services Ltd. Used with permission.

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