Rebalancing your portfolio annually

Source: When It Comes to Rebalancing, a Little Means a Lot By PAUL J. LIM of nytimes.com

Over the long term, stocks tend to outperform bonds.

If you have not rebalance your portfolio for several years, chances are that you probably have more exposure in stocks than you intended.

Moreover, you are probably overexposed to the most volatile types of stocks.

So some rebalancing may be better than no action at all.

Example of asset allocation

Over the last half-century, the worst one-year stretch for a portfolio of 60 percent stocks, 30 percent bonds and 10 percent cash was a loss of 24.1 percent. That occurred in the 12 months that ended in September 1974.

By comparison, the worst one-year loss for a more conservative mix — 40 percent stocks, 40 percent bonds and 20 percent cash — was just 15.5 percent during the same period.

Yet to achieve this lower risk, you would have to give up a decent amount of gains. The switch in asset allocation strategy would have reduced your average annual returns to 8.3 percent from 9.2 percent.

Rebalancing your portfolio once a year

Say you started investing at the end of 1984, in a portfolio consisting of 60 percent stocks, 30 percent bonds and 10 percent cash. And further assume that you never rebalanced this portfolio back to that 60-30-10 ratio. Instead, you let the market take your investments for a ride.

Through the end of June, this strategy would have earned an average annual gain of 11.1 percent since 1984.

Now, had you started in 1984 with the same strategy, but this time rebalanced your portfolio annually, you would have earned nearly as much on your investments: 10.7 percent a year, on average.

But at the same time, that portfolio would have been 18 percent less volatile, based on standard deviation.

The buffering effect of rebalancing might have been enough to let you sleep better at night.

More on rebalancing

Rebalancing is not just about resetting your mix of stocks and bonds. You should also consider periodically resetting the types of stocks you own.

For instance, over the last five years, many of the best-performing areas of the stock market have also been among the most volatile.

Those include the basic materials, telecommunications and technology sectors, all of which have a “beta” of more than 1.0. (Beta measures the tendency of an investment to go up or down, relative to the market — in this case the S&P 500 index. So a beta of more than 1 implies that if the S&P 500 were to rise or fall 5 percent, for example, that investment would rise or fall even further.)

On the other hand, two of the lowest beta sectors in the market — health care stocks, with a beta of 0.6, and consumer staples stocks, at 0.5 — have been the market’s worst performers over the past five years.

One way that investors might consider rebalancing the stock portion of their portfolios is to gravitate toward areas with lower volatility, like health care and consumer staples, while avoiding those highly volatile areas that have already done exceptionally well..

Another way to rebalance — without selling any holdings — is simply to take your new money and invest it in areas that many investors have ignored in recent years, like large-capitalization domestic growth stocks and stock funds. These may be worth buying now.