The benefits of rebalancing a portfolio
One critical component to success in investing many believe is to follow the age-old maxim "buy low and sell high". Unfortunately for most investors this is more easily said than done. Rebalancing is the process of selling portions of ones investment in a particular asset class or security that has grown as a percentage of the portfolio to a level beyond its intended or target allocation. Proceeds from the sale are used to buy additional portions in another asset class or security that has fallen below its intended target allocation. In other words, "Buying Low and Selling High".
Here are two hypothetical portfolios both initially comprised of 60% common stocks and 40% bonds, neither is rebalanced and both are potentially dangerous.
The first portfolio starts out in 1994. By the end of 1999 stocks had grown to represent nearly 80% of this hypothetical investor's portfolio. Going into the years 2000, 2001, and 2002 an allocation of 80% stocks could have been very painful. Had the portfolio been rebalanced periodically, this investor would have entered the bear market with less exposure to stocks.
The second portfolio starts out in 2000, again with 60% stocks and 40% bonds. Because this investor did not rebalance his portfolio, his stock allocation dropped down to only 40% by the end of 2002. Had this investor periodically rebalanced his portfolio back to the original 60% stocks and 40% bonds weighting he would have had had a greater weighting in stocks going into the bull market of 2003.
Studies have shown that periodically rebalancing an investment portfolio between different asset classes such as stocks, bonds and real estate can significantly reduce the overall risk or volatility in your portfolio. For many investors, this means a smoother ride towards their financial goals making the process of investing less emotional. Not only can rebalancing between asset classes and investment styles reduce your portfolios volatility it may also enhance it's returns over time.