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By Abby Woodham

In my last article, I introduced three exchange-traded fund portfolios for young investors to use within a taxable brokerage account. Because asset allocation is the most significant decision an investor makes, the portfolios were constructed to take advantage of the simplicity and cheapness of ETFs with the time horizon and needs of a young investor in mind. The next actionable step, and one that few young investors take, is to pick a rebalancing strategy. We'll explore the importance of rebalancing and the different methods that make the most sense for a young investor using the ETF portfolios. Rebalancing can help instill a disciplined mindset, which is especially important and useful for new investors.

The primary function of rebalancing is to control risk. The varying performance of asset classes over time causes a portfolio to shift away from its target asset allocation. For example, riskier assets exhibit more volatility, but also tend to outperform safer investments. Over time, as their proportional share grows, the risk of the portfolio drifts away from the target. Rebalancing controls this risk by moving capital between investments to re-establish the target asset allocation.

Rebalancing also can boost return. In practice, rebalancing means selling high and buying low, which is a hallmark of disciplined investing. The long-term trend for the market is to go up, so pruning an outperforming asset class and shifting the capital into an undervalued asset class improves return. Rebalancing also can help investors in a down market. Research shows that when investments decline sharply in value, they are likely to produce high returns in the near future.

There are various rebalancing methods, but no "one-size-fits-all" strategy. The most commonly used strategy is time-based--for most investors, a quarterly or annual rebalance is appropriate. Rebalancing also can be triggered by a threshold. If an asset class grows to be a predetermined percentage larger than its target allocation, the portfolio is rebalanced. Research by Vanguard shows that both methods are effective. One simple way to rebalance is to direct new money and dividend payments to underweight asset classes. Determining the right tactic depends on the needs of the individual investor and the cost of executing the strategy.

Although it is a productive and relatively simple process, most investors don't rebalance. The simple explanation is that they don't spend the time to do it; the behavioral finance explanation is that investors experience a disproportionate response to fluctuations in the market. During a bull period, investors typically are willing to take on additional risk (who wants to opt out of market rally?) even though the probability of continued outperformance is low. Investors will maintain their position in risky assets that have grown faster than the rest of their portfolio, and sometimes will even add additional capital to those asset classes. Conversely, investors become risk-averse during a bear market. Fearing further wealth destruction, they resist the idea of rebalancing into the asset classes that have already lost money. The greater the preceding loss, the greater the risk aversion.

Young investors are particularly susceptible to this mindset because of their relatively small investable assets. Recent college grads have little investable capital. With only a few thousand dollars to invest at best, every basis point of decline is felt acutely. Although over the long term, rebalancing preserves the risk target of a portfolio, it can introduce short-term volatility during a market downturn. Young investors, already rattled by a significant decline in their purchasing power, can be even less likely to rebalance than their older counterparts.

However, young investors are the ideal candidates for rebalancing, which instills the principles of disciplined investing. Learning valuable investing behaviors at a young age is perhaps the most important benefit to rebalancing. When investors are constructing a portfolio, they are aware of risk tolerance. Setting and following a strict set of rebalancing rules can be used as protection from irrational fears down the road. Additionally, young investors' long investing time horizon means they can weather temporary volatility without worrying that the market will not improve before retirement. These investors need to internalize that the money they invest in a long-term portfolio has more than 40 years to mature. Volatile periods, even ones as destructive as 2008-09, are temporary over a longer time horizon.

The right rebalancing schedule for young investors should include several elements: implementing a strict rebalancing schedule to encourage discipline, minimizing the frequency that the portfolio is examined, and effective risk control. The difference in risk and return between daily, monthly, quarterly, and annually rebalancing is minimal, especially after costs. Because all of the recommended ETFs from the model portfolios trade commission-free, transaction costs are not a concern, but for tax and psychological purposes, it is still wise to minimize the frequency of rebalancing events.

The simplest method for young investors is to rebalance quarterly (as suggested in my previous article) or annually. Annual rebalancing is a sensible method for the most risk-averse investors, who should check on their portfolios as infrequently as possible. For more hands-on investors, rebalancing quarterly with a 5% threshold makes sense. At the end of every quarter, calculate what percentage of your portfolio's total worth is allocated to each asset class. In the model portfolios, each asset class is neatly contained in a single ETF, so the process should be simple. If an asset class' allocation has drifted beyond its target by 5% or more, rebalance the portfolio.

Young investors should use new portfolio contributions to rebalance in conjunction with their chosen strategy. The frequency at which new money is added varies from person to person, but using portfolio inflow to additively tweak asset allocation is very tax-efficient. Happy investing!

Disclosure: Morningstar, Inc. licenses its indexes to institutions for a variety of reasons, including the creation of investment products and the benchmarking of existing products. When licensing indexes for the creation or benchmarking of investment products, Morningstar receives fees that are mainly based on fund assets under management. As of Sept. 30, 2012, AlphaPro Management, BlackRock Asset Management, First Asset, First Trust, Invesco, Merrill Lynch, Northern Trust, Nuveen, and Van Eck license one or more Morningstar indexes for this purpose. These investment products are not sponsored, issued, marketed, or sold by Morningstar. Morningstar does not make any representation regarding the advisability of investing in any investment product based on or benchmarked against a Morningstar index.

Source: On The Importance Of Rebalancing