Rebalancing Act

My previous entry on reversion to the mean may have seemed a little academic, but it has a very practical application in managing your portfolio. Over time investments, like closets, tend to become disorganized. You may have spent considerable time and effort in setting up an asset allocation for your 401k, but if you stop there you will eventually have a portfolio that no longer meets your needs, and could potentially expose you to much more risk than you originally intended.

Rebalancing your portfolio can insure that your risk remains tolerable, and can actually improve your investment returns over time. There is always disagreement over when you should rebalance, some prefer quarterly, some monthly, some have complicated formula's that trigger rebalancing. You can put me in the annual camp. When I have looked at hypothetical portfolios and compared annual to quarterly rebalancing I usually find that annual rebalancing provides more return, while quarterly rebalancing does a better job of reducing risk. No matter what choice you make, the process of rebalancing can benefit you.

The reason rebalancing works is that "reversion to the mean" shows that different asset classes and subsets within those classes go through periods of under performance and out performance. By rebalancing your portfolio you force yourself to take some profits in areas that are outperforming, and purchase securities that have become relatively cheaper. This goes against human nature because we all tend to want all our money in whatever is providing the best return right now. Just remember that all things in life have cycles. You may not be able to predict when a cycle will begin or end, but you do know that it will. Rebalancing provides discipline to your investment process and can keep you from making the big mistake of being late to the party and late to leave, like the dot com investors of the last bull market.

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