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By Gregg Fisher, CFA

The first three quarters of 2012 have been marked by handsome increases in stock prices, modest rises in bond and commodity prices, and generally declining stock market volatility. While these are welcome developments, investors should not get complacent going into the fourth quarter - nor be tempted to let their equity allocations run up as their market value increases rather than paring the allocations back as part of a disciplined rebalancing practice.

You can look at rebalancing as a form of portfolio risk management. Let's say you've set strategic asset allocations at 60% stocks, 30% bonds, and 10% commodities as part of an investment policy statement that reflects not only your desired exposure to systematic risk factors but also the risk and return goals of your portfolio. If you allow allocations to drift as asset prices fluctuate over time, however, the more volatile asset classes will tend to take over and increase portfolio risk - hence, the need for periodic rebalancing.

Building a Better Portfolio
Implemented over extended periods, systematic rebalancing may improve a portfolio's risk-adjusted returns quite substantially. For example, we looked at two portfolios comprising 60% stocks, 30% bonds, and 10% commodities from 1 January 1992 to 31 August 2012 (for this exercise, we used a portfolio allocated as follows: 60% S&P 500 Index, 30% five-year Treasuries, 10% Dow Jones-UBS Commodity Index).

We rebalanced the first portfolio each quarter and never rebalanced the second one. Result: The rebalanced portfolio returned 7.86% annualized, compared with 7.42% for the second one. Thanks to the power of compounding, a $100,000 investment in the rebalanced portfolio would have grown to $478,000, compared with only $439,000 in the case of no rebalancing, for an 11% greater profit. Rebalancing also reduced portfolio volatility quite dramatically, from 10.74% to 9.43% over the 20-year period. Overall, rebalancing resulted in a 21% improvement in the portfolio's reward/risk ratio.

There are, of course, different methods and philosophies of rebalancing. For instance, calendar rebalancing calls for returning allocations to target weights on a periodic basis, such as quarterly or semi-annually. This is a fairly simple process that doesn't require continuous monitoring of a portfolio, but the downside is that calendar rebalancing is unrelated to market behavior that may have moved allocations way out of whack since the last rebalancing.

Establishing Some Rules
Many investors follow a form of percentage-of-portfolio rebalancing whereby thresholds or trigger points for rebalancing are established. For instance, take the simple example of a 60/40 strategic allocation with a 5 percentage point rule. This approach results in a tolerance band or corridor of 55%-65% for stocks and 35%-45% for bonds. If stocks or bonds move out of those ranges, that would be the trigger to rebalance the entire portfolio. Another common technique is percentage of asset class - for instance, using a 10% movement (say, from 40% to 36% or 44%) as the threshold to rebalance.

Regardless of what method you use, there are some basic guidelines to bear in mind. First, because transaction costs are incurred each time you rebalance to strategic allocation targets, you must determine whether the trade-off is worth it. All else being equal, it is better to set wider corridors for illiquid investments with high transaction costs, such as real estate and private equity. If the portfolio is in a taxable account, you'll probably want to set wider bands than in a tax-deferred account. To help minimize transaction costs in the rebalancing process, consider using incoming cash deposits like 401(k) contributions or interest and dividend income generated by the portfolio.

Second, the higher the volatility of an asset class, the narrower the corridors should be. For example, commodities will typically have a tighter band than high-quality fixed income. And the higher the correlation of an asset class with the rest of the portfolio, the wider the optimal corridor. You should also note that for investors who seek exposure to certain risk factors within an asset class - for instance, small cap versus large cap, value versus growth, or international versus domestic within equities - it makes sense to drill down and set some rules for rebalancing risk factor exposures (with the caveat that, as with asset class rebalancing, such changes should be justified by the related transaction costs).

Finally, don't forget to rebalance portfolios in your defined contribution retirement plan, such as a 401(k). In managing their own defined contribution accounts, investors seem prone to what is called status quo bias in behavioral finance. In other words, perhaps out of sheer inertia, some people take a "set it and forget it" approach to their retirement portfolios, allowing allocations to drift until asset class weights and risk levels are way out of kilter. As one extreme example, consider the cost of riding equities (and tech stocks in particular) all the way until the market bubble burst in March 2000.

Conclusion
Periodic portfolio rebalancing is more than just a prudent risk management practice. Over time, it can increase portfolio returns and reduce risk. There are many ways to structure a rebalancing methodology, but the most important thing is that investors must have one - and stick to it.

Source: Discipline's Reward: The Power Of Rebalancing