By FPA member Eric S. Toya, CFP®

Last Updated: June 6, 2011

Most investors know that diversification is an important part of a sound investment strategy. Long before you learned the ins and outs of stocks, bonds, mutual funds, exchange-traded funds (ETFs) and all other manners of investment vehicles, you learned the phrase “don’t put all of your eggs in one basket.” The idea of diversification is the basis of sound investment advice. As investors in internet stocks in the late 90s or Enron employees who loaded up on company stock learned, any single company or single sector has the potential for devastating losses.

If you have learned from your (or hopefully others’) past mistakes, you have diversified your portfolio across a number of major asset classes. Depending on your appetite and tolerance for risk, you likely have part of your portfolio in U.S. stocks, both large and small, international stocks, again both large and small, fixed income, emerging markets and perhaps commodities or real estate investment trusts (REITs).

Regardless of how well you have diversified your holdings, your portfolio is not like a chicken in an electric rotisserie oven; you cannot just “set it and forget it.” Similar to your electric rotisserie oven, your portfolio consists of various moving parts. However, unlike your electric rotisserie oven, those parts do not move in tandem. In fact, the goal of diversification is just the opposite — you want one part of your portfolio to zig while the other zags.

That’s not all. The part of your portfolio that zigs (goes up) may continue to zig for an extended period. This will cause that part of your portfolio to become disproportionately large relative to the original, or target, allocation. Simple math tells us that if it is disproportionately large, then other asset class(es) have become disproportionately small. Using a simple example, if you have a 60/40 target mix of equity to fixed income, a period of rising prices in stocks may result in your portfolio looking more like 70/30. In this case, it is time to rebalance.

Rebalancing is simply the process of selling a portion of your overweighted investments, and using the proceeds to buy more of your underweighted investments. This is an important part of the ongoing management of your portfolio. Effectively, it forces you to sell the asset class that has been performing best and buy the one that has been performing worst. And you are going to pay transaction costs for the pleasure of doing so. Not an easy thing to do psychologically. Did I mention that, unless this is in a tax-sheltered account, you will also likely incur taxes in the process?

Given all this, why bother? Shouldn’t well enough be left alone? 

Not according to Sheryl Rowling, CPA/PFS, Partner at Moss Adams Wealth Advisors. Rowling says, “To maintain consistent risk/return parameters, periodic rebalancing is necessary. Many will argue that periodic rebalancing is not necessary because if we allow portfolios to drift, they will become overweighted in higher performing asset classes. Thus, returns will increase over the long-term. Combine that with avoided tax and transaction costs on rebalancing transactions, it seems like ‘not fixing what ain’t broken’ might be the way to go! Unfortunately, if we don’t keep portfolio proportions consistent through market swings, we can’t limit volatility to within the original parameters.”

Think about it this way, systematic rebalancing forces you to sell high and buy low. Keep in mind that yesterday’s best performing investment could be tomorrow’s worst, and vice versa. In the simple example above, by allowing the portfolio to remain at 70/30, you are leaving your portfolio exposed to greater risk in the event that stocks decline.

How should you rebalance?

There are a number of methods that you can use, but the most important thing to keep in mind is that rebalancing should be systematic. The idea is to avoid changes in your portfolio at random times, when you “feel” that certain stocks or asset classes are going to keep going up, or may be headed for a downturn. Ad hoc, non-systematic changes to your portfolio of this nature essentially amount to market timing. Most research indicates that the majority of investors cannot effectively time the market.

There are a couple of schools of thought on the best way to systematically rebalance. The simplest and most straight forward method is to simply rebalance your portfolio at fixed time intervals; annually is common, while others rebalance as frequently as quarterly. Rebalancing at fixed time intervals forces discipline on a regular basis and prevents ad hoc, market timing decisions.

Recent research has indicated that the most effective form of rebalancing is not based on the calendar, but based on a predefined acceptable allocation range for each asset class. For example, you may determine that the acceptable range is 10 percent above or below each asset class’ target allocation. Based on this, using our earlier example of a target portfolio of 60/40, your acceptable allocation range for stocks would be 54-66 percent (10 percent of 60 is six percent, so your range is six percent above or below your target allocation). If stocks grew to greater than 66 percent of your portfolio, it would trigger a rebalancing. You would sell some of your stocks to bring it back down to 60 percent and use the proceeds to buy bonds, which, in this example, would have dropped to 34 percent. The end result would be a portfolio properly allocated with 60 percent in stocks and 40 percent in bonds.

The benefit of this method is that you are more effectively implementing the “buy high, sell low” aspect of rebalancing. Major spikes or drops in the market don’t necessarily happen at the end of the quarter or year. The difficulty with this method is that it requires daily, or near daily monitoring of your portfolio. Many professional financial planners use sophisticated software that helps them identify when a portfolio is out of balance and requires rebalancing.

There are tools and software that are also available to individual investors. Check with your online broker. Firms like T.D. Ameritrade and Schwab have tools available on their websites that can help you rebalance your portfolio. Also, various household money management tools such as Quicken or Mint.com have rebalancing calculators built into the software. Of course, some investors simply build a spreadsheet and update their portfolio regularly. This is the most tedious method, requiring frequent data entry and subject to human error.

FPA member Eric S. Toya, CFP®, is Vice President of Wealth Management for Trovena, LLC in Redondo Beach, Calif. Eric graduated from the University of Southern California with a BS in Finance and Accounting. Eric has been quoted in national publications, including The Wall Street Journal, Money Magazine and the Los Angeles Times.