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Leaving your portfolio to fend for itself could end up exposing you to more risk than you're willing to take.

Question: If my portfolio is built around a solid asset allocation model based on decades of relative performance between different asset classes, why should I rebalance every quarter or year, as is often recommended? Won't the long-term market results naturally rebalance the portfolio for me? Besides, won’t rebalancing reduce my returns over time? I've never seen any numbers that support rebalancing. To me, it's like an urban myth. —David Lufkin, Boston, Mass.

Answer: What? Rebalancing your portfolio an urban myth? Next you’ll be telling me that Bigfoot is just a hoax or that Jimmy Hoffa really isn’t buried in the end zone of Giants Stadium.

Seriously, I like your question because I think it’s worthwhile to challenge the truths we hold to be self-evident, if for no other reason that verities sometimes become distorted or misunderstood over the years . For that matter, some of our most cherished truisms, like the value of dollar-cost averaging, may not be all they’re cracked up to be.

So it’s good to step back and take a critical look at these accepted beliefs before they cross the line from truth to dogma, which Nobel economist Paul Samuelson once told me, is “a truth so truthful that we dare not question it.”

So let’s take a closer look at rebalancing. I’ll start with the issue of whether you need to actively rebalance or whether the ups and downs of the markets will automatically do it for you, as you suggest. Then we’ll move on to the question of whether rebalancing makes sense at all.

'Natural' rebalancing

To a certain extent you’re correct that if you create a mix of different assets (and to keep it simple let’s just stick to a two-asset portfolio of stocks and bonds), reinvest all gains and otherwise leave your portfolio alone, the ebb and flow of returns that those different assets earn year to year will automatically rebalance your portfolio. In years when equities outperform, the market will tilt your mix more toward stocks, and in years when bonds excel, your portfolio will shift back more toward bonds.

Problem is, unless you believe that bonds will outperform stocks over the long term, the longer you hold that portfolio, the more your allocation, left untended, will gradually shift more toward stocks over the years, as you accumulate more gains in stocks than bonds.

Even more important, though, is that if you don’t rebalance, the less likely it is that at any given time your portfolio will be operating at the original stocks-bonds mix you set. Depending on when you create your portfolio and how different asset classes perform, it will be either too aggressive or too conservative.

Let’s say at the beginning of the 1990s, you had invested $100,000 and decided on a mix of 70% stocks and 30% bonds, and then left your portfolio untouched.

Since stocks annualized returns over that decade outpaced those of bonds by a margin of more than two to one - 18.2% vs. 7.2% - you would have had a very stock heavy portfolio by the end of 1999. Your original $70,000 in stocks would have ballooned in value to nearly $373,000, while your bond stake would have grown to just over $60,000. That means your 70% stocks-30% bonds mix would have morphed to a much more aggressive 86% stocks and 14% bonds by the end of the 1990s.

But from 2000 through 2002, stocks lost roughly 38% of their value and bonds gained about 37%. So by the end of 2002 the stock portion of your portfolio would have sunk to just over $232,000, while the bond climbed to nearly $83,000, giving you a mix of 74% stocks-26% bonds. That’s less equity-intensive than it had been at the end of the go-go ‘90s, although not back to its original 70%-30% proportions.

And where would your portfolio be now? Well, since 2002 stocks have again outpaced bonds by a considerable margin - up roughly 61% vs. 20% from the beginning of 2003 to present - bringing the value of the stocks’ portion of your portfolio to roughly $375,000 and the bonds’ to a little more than $99,000, for a 79% stocks-21% bonds mix.

So in this little example, we’ve seen the 70% stocks-30% bonds mix you set at the beginning of 1990, go as high as 86% stocks-14% bonds, drop to 74% stocks-26% bonds and then climb back to 79% stocks-21% bonds.

Benefits of rebalancing

You might say, well, what’s the big deal? I started at 70-30, moved up to 86-14 and I’m now at 79-21. I’m not so far off where I started. It’s no biggie.

But look at it this way. When you set your stocks-bonds mix, what you’re really doing is saying how much risk you are willing to accept for a given return. That’s the whole point of asset allocation - getting an acceptable balance of risk and reward. By letting the stock and bond markets effectively re-set your allocation, you were undermining your own strategy. You essentially gave up control of your portfolio.

Failing to rebalance cost you in another way too. In the 90s, at the very time that equities were becoming more and more overvalued, you were increasing your stake in them relative to bonds by reinvesting most of your gains in stocks. So by the time bonds were about to go on a three-year run from 2000 through 2002, you had reduced the percentage of your portfolio invested in them by more than half to just 14%, leaving you less prepared to take advantage of their upswing. And by letting your equity stake grow from 70% to 86%, you were more vulnerable to stocks’ meltdown.

The major benefit of rebalancing is that is that it prevents the risk profile of your portfolio from getting out of whack. But it also it forces us to do what we know we should do but rarely do on our own: buy low and sell high. By rebalancing, you sell a portion of assets that have been on a roll (and therefore are more likely to be overvalued or approaching that status) and plow the proceeds into assets that have been lagging (which are more likely to be undervalued or approaching bargain territory).

But you don’t engage in a guessing game like market timers do. You do it in a systematic, disciplined way, within the limits of the asset allocation you set. But you do benefit from lightening up on assets when their valuations are more likely to be gaseous (as stocks were in the late ‘90s) and putting more money into assets that are more likely to be poised for bigger gains (as bonds were when the ‘90s party ended).

Less return, less risk

As for whether rebalancing reduces your return, I suppose the answer is yes, assuming that stocks will outperform bonds over the long term. That’s because rebalancing works against the natural tendency of your portfolio to gradually become more stock heavy over the years.

But, frankly, I don’t think that’s the right way to think of rebalancing. After all, if return were the only consideration and risk wasn’t a factor, no one would bother with asset allocation. You would just plow all your money into stocks or whatever asset you thought would generate the highest returns.

So, actually, it’s setting an asset allocation for your portfolio that dilutes your portfolio’s potential gain (in return for less risk). Rebalancing just assures that your mix stays on track - and that you continue to get returns in line with the risk you’re willing to take.

Bottom line: it seems to me that the real issue is whether you believe in the value of asset allocation. If you don’t, then rebalancing isn’t an issue. Without an asset mix, what’s to rebalance?

But if you do see value in asset allocation, then I find it hard to understand why you wouldn’t rebalance. I’m not saying you’ve got to be a fanatic about it. I think once a year ought to do it, although there are a variety of methods than can work (including putting any new money you’re investing into lagging classes).

But what’s the point in going to the trouble of setting an asset mix if you’re not going to maintain it and reap the benefits of asset allocation? I think that if you could catch Bigfoot and ask him, even he would agree that there’s no sense in that.