If, in 1990, you invested $10,000 and split the proceeds, $5,000 in Apple Stock (AAPL) & $5,000 in Microsoft Stock (MSFT) and reinvested all the dividends - what do you think the market value of your investment would be today?
The answer: $1.35 million as of 1/31/2017 ($790k of Microsoft & $560k of Apple)
If in every quarter during that same time period you rebalanced your stock mix back to 50% AAPL and 50% MSFT, would the value be higher or lower?
The answer: $2.61 million - almost double ($1.31 million of Apple & $1.30 million of Microsoft)
Rebalancing is a form of Risk Management and when implemented over extended time periods, tends to improve a portfolio’s risk-adjusted return substantially. Although the Apple/Microsoft example is extreme, the concept is the same for diversified portfolios as well. So how does it work? Let’s say that you have completed a financial plan and your target asset allocation is to invest 60% in stocks and 40% in bonds. After one year your stock portion increased in value and now makes up 70% of the portfolio. You are now taking on more risk than your financial plan dictates. By triggering a rebalance, it shifts the increased risk back to the target portfolio of 60% stock 40% bond by selling the “winners” and buying the “losers.”
This concept forces you to sell high and buy low, a tough thing to do on your own because who really wants to sell their winning positions and buy the losing ones. This is exactly what occurred in Apple/Microsoft example. Periods when the MSFT was outperforming AAPL, the rebalancing forced selling Microsoft at a high and buying Apple stock at a low and that strategy greatly rewarded the investor.
At Thrive we believe everyone needs a financial plan and we let the plan drive how the investment allocation is implemented. Rebalancing is a portfolio management technique that not only keeps your target asset allocation in line but also manages Investor Behavior (keeping exuberance/greed and fear in check). The bottom line is to stay disciplined, stick with the plan, and you will most likely reap the rewards of your efforts.