Rebalancing for the Real World
"Investing is a marathon -- not a sprint. The prize goes to those with fortitude and endurance."
--Burton G. Malkiel
What is Rebalancing, and Why Should I Care About It?
Much of your investing success or failure will likely hinge on your asset allocation -- how you deploy your investments among major asset classes such as stocks, bonds, real estate, and cash. In the 1980's legendary investor Gary Brinson and colleagues argued that fully 90% of the variation in investment returns is due to asset allocation, as opposed to market timing or stock selection. Even more significantly, asset allocation is one of the few investment factors you control with certainty. You can never be certain that you are buying or selling the right stocks at the right time. But you can be certain about the percentage of stocks, bonds, and other asset classes in your portfolio.
Choosing an appropriate mix of investments for your personal time horizon and risk tolerance can be key to maximizing your returns while minimizing your risk. Although numerous books are available on the topic of asset allocation, far less information is available on the details of maintaining that balance -- rebalancing -- as the market cycles over time. Rebalancing is a potentially critical, but often overlooked, aspect of managing your portfolio for the long term. By "rebalancing" we mean changing your current asset allocation to move it closer to some previously-decided target allocation. (In a garden, if you decide that Morning Glories should be 10 percent, but they grow wildly and take up 25%, you cut them back to make room for other plants. That's rebalancing.)
Why rebalance? Years of research and practical experience indicate that asset classes perform on different, independent cycles. One will be up for a few years, then another will take its place. For example, from 2005 through 2007, international stocks were the highest-returning asset class. In 2008 they were the lowest. Instead, bonds were the leading asset class. But in 2009 bonds were second to last. Rebalancing theoretically "locks in" a portion of the profits earned by your winners, and ensures the losers are in a position to help, when their turn comes to shine.