One of the cornerstones of asset allocation is the concept of rebalancing. Done correctly, rebalancing forces you to buy certain investments when they are undervalued (cheap) and sell when they are overvalued (expensive). In effect, it makes the owner of the portfolio a value investor without the need to analyze individual companies. It can even be taken one step further with something known as tactical asset allocation.
How Rebalancing Supports Your Asset Allocation Strategy
Imagine that you have a portfolio with a $100,000 market value. You follow the Benjamin Graham asset allocation model and begin by putting 50% of your money, or $50,000, in stocks, with the remaining 50% put into bonds. You select the Dow Jones Industrial Average iShares (Ticker Symbol IYY) and the Vanguard Intermediate Term Bond ETF (Ticker Symbol BIV).
At the end of the year, your bond holdings have appreciated by 5%, bringing the value of your bond component to $52,500. Your stock holdings appreciated 11%, bringing the value to $55,500. Your combined portfolio value is now $108,000. Your asset allocation exposure now consists of 48.611% bonds and 51.139% stocks. You can see how, over time, your asset allocation could drift far away from your intended asset class exposure.
Rebalancing would require you to reset your portfolio value to 50% stocks and 50% bonds. In this case, your portfolio has a market value of $108,000 so you’d need $54,000 in stocks and $54,000 in bonds. That means you would sell $1,500 of the Dow Jones ETF and buy $1,500 of the bond ETF. If stocks are experiencing a bubble as asset prices rise, you are now somewhat protected by maintaining your target asset allocation mix. However, you are still prospering from a rise in the market because you own more stock in an absolute sense. Remember, you started the year with $50,000 in stock and ended it with $54,000 in stock. You own $4,000 more worth of the Dow Jones ETF than you did.
Is Asset Allocation Rebalancing Cutting the Flowers and Watering the Weeds?
The bottom line is, only you and your advisor can decide what is right for your financial situation, needs, and risk tolerance. Whether you are willing to risk parting with some of the upside in exchange for insurance against total loss is a decision you need to make for yourself.