The real value of rebalancing your portfolio

An annual evening of the scales is good discipline

One under-appreciated problem with investing is "analysis paralysis": you can spend so much time trying to figure out the best way to do something that you end up doing nothing at all. Take rebalancing, viewed by many as an investment basic. First, you decide on a suitable asset allocation (say 60% equities, 40% bonds). Then, when the allocation gets too far out of line with your initial plan, as a result of market moves, you top up or sell the excess as necessary. So, if after a year 65% of your portfolio is in equities, and 35% is in bonds, you sell equities and buy bonds until you're back at 60/40.

That's all very well, you might think but then you start looking into it, and you find a huge range of conflicting views on rebalancing: when and how to do it, and whether to do it at all. So what's an investor to do? The main argument for rebalancing, as Buttonwood in The Economist puts it, is that "it works against the boom-bust cycle". In effect, it leads you to favour cheaper assets over expensive ones, which is surely good in the long run.

Or is it? Michael Edesess, chief investment strategist at Compendium Finance, is a dissenting voice. He argues that most researchers are too selective with their results. His data suggests that rebalancing does beat buy-and-hold by a little bit, roughly two-thirds of the time. However, on the remaining third of occasions, buy-and-hold wins out by quite a large margin. So in the long run, the two cancel each other out neither is best.

So don't bother? It's not that simple. As I noted above, analysis paralysis is a big threat in investing. Rebalancing might not definitively beat buy-and-hold in theory, but it may well help you to steer clear of common investment mistakes, such as panic selling at the bottom or euphoria buying at the top. As Edesess himself put it on the Advisor Perspectives website: "Rebalancing is certainly not necessarily harmful It is better to have an investing discipline than not to have one, and rebalancing is one acceptable default discipline especially when the investor would fail to adhere to any discipline if his portfolio's volatility exceeded a particular level."

So arguably the real benefit to rebalancing is psychological it helps you stay the course when markets run into turbulence. Given that, and to avoid the temptation to fiddle too much, we'd suggest that rebalancing annually makes sense for most. Also, if you are saving regularly rather than managing a lump sum, it's probably most cost-effective to rebalance by adjusting your monthly (or quarterly) contributions in order to save more into the underweighted asset, rather than selling out of the overweighted one.