So now that you have engineered a portfolio that is suitable for your risk tolerance, it’s crucial to develop a process for maintaining that strategy in the most cost efficient way possible.

You don’t have to do anything to your portfolio for it to change. That’s because some of your investments will do particularly well while others won’t. That was the whole point of diversifying your portfolio in the first place. Investments that have done well will naturally begin to take up more of your portfolio: Those that haven’t done as well will take up less of your portfolio. And you don’t have to do a thing for that to happen. Rebalancing is about managing the risk in your portfolio and keeping you in line with your investment objectives.

What is Rebalancing?

Rebalancing is the process of buying and selling portions of your portfolio in order to set the weight of each asset class back to its original state. Rebalancing will help you stick with your investment plan regardless of what the market does. Rebalancing is the simplest, and yet one of the most powerful, ways of buying low and selling high, while minimizing potential risk in the portfolio.

Why is it important?

Rebalancing is important because it’s the process that maintains the allocation that’s right for you. Since Modern Portfolio Theory states that approximately 92% of your return comes from your allocation, it’s crucial that investors stick to their investment strategy. Rebalancing is primarily about risk control, or making sure your portfolio isn’t overly dependent on the success or failure of one investment, asset class, or style.

Although this seems reasonable and easy to do, it’s not. Rebalancing is counterintuitive to how our brains think. You probably have never had someone say, “I can see why you stick with that guy—he’s a real loser!” Everyone prefers a winner.

So if an investment is successful, naturally, you’d want to stick with it. The last thing you’d want to do is sell some of your winners to invest more money in your investments that aren’t doing as well. Buying when prices are going through the floor is difficult. Selling when prices continue to rise through the stratosphere is equally hard. Rebalancing forces you to do both.
No matter how unnatural that practice seems, however, that process—called rebalancing—is an essential part of managing your investment portfolio. It’s the disciplined execution of your investment strategy. A good rebalancing policy will be automatic and eliminate the human element (acting on emotion), which plagues most investors.

There is another less-well-known benefit to the rebalancing exercise. In volatile markets, it can boost returns as well as lower your risks. This is known as a “rebalancing bonus.”

From January 1927 through December 1940 (a period that includes the Great Depression) a portfolio of 100% U.S. stocks posted total returns, including reinvested dividends, of 81% according to a 2012 report by Columbia Business School professor Andrew Ang. A portfolio of 100% U.S. government bonds returned 108%. But a portfolio of 60% stocks and 40% bonds, rebalanced quarterly, beat both by a wide margin, with a return of 146%.

More recently, if you hadn’t rebalanced at the beginning of 2007, reestablishing equal positions in the funds, you wouldn’t have lost half as much during 2008. Rebalancing would have protected a sizeable chunk of the gains you made prior to the crash of 08.

An investor who rebalanced their portfolio quarterly effectively cashed out stock-market gains during booms and put some of their profits into bonds, and then bought the stocks back, at much cheaper prices, during selloffs.

The wider the array of assets (true diversification), the more independent they are of one another, and the more volatile the markets, the better the gains are likely to be. No one investment style stays in favor forever. In the mid 1990’s all investors cared about were financial stocks. Then from the late 1990’s until March of 2000, technology stocks were the favorite among the masses. After that, the hot investments were REITS. Bonds have been in vogue ever since the bear market of 07-09. In the bear market, nearly all stocks were hammered, but high quality bonds were up just fine.

And that’s the whole point of rebalancing: you don’t know what asset class, sector, or investment style is going to rule the investment world next year, or how rapidly things might change. Rebalancing helps you reap the full rewards of diversification. Trimming back on a winner allows you to buy a laggard, protecting your gains, and positioning your portfolio to benefit from a change in the markets favorites.