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Hands with money and scales

Hemera Technologies

There's a balancing act when it comes to rebalancing your portfolio. The goal of rebalancing is to maintain your target asset allocation, and therefore keep your portfolio's risk characteristics in line with your risk tolerance. But there are other advantages, and disadvantages, worth knowing.

Asset allocation comes down to more than just the split between stocks and bonds, but for today's column, I'll stick to this rudimentary break down.

Stocks in general are expected to outperform bonds over very long periods of time. The expected outperformance is known as the "equity premium." As an aside, Dr. Kenneth French, professor of finance at Dartmouth College and co-author of one of the most important research papers in finance academia of the last 20 years, The Cross-Section of Expected Stock Returns, stated during a presentation I attended (before the credit crisis) that we need 30 years before the equity premium shows up reliably from a statistical perspective. This is a strong argument for incorporating fixed-income positions in a portfolio, and a stronger argument for adopting a rebalancing protocol.

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In pure theory, if one's investing career spanned more than 30 years, then allocating 100 per cent of a portfolio to stocks should make you the most amount of money. Then again, in theory, theory and practice are the same, but in practice, they are not. Most people cannot stomach the volatility of a 100-per-cent equity portfolio. And for the countless investors before and countless future investors, they tend to abandon their strategy at the most inopportune of times.

By including a fixed-income component and coupling this with a rebalancing protocol, you are more likely to succeed. With a few exceptions, bonds and stocks follow different return patterns. If you've settled on a 60-per-cent stock, 40-per-cent bond portfolio, it won't stay that way for long. One of the great things about rebalancing is that it forces you to buy low and sell high.

For example, if stocks outperform bonds, then perhaps your allocation drifts to 65/35. To rebalance that back to 60/40 requires you to sell some stocks and buy some bonds. That means you sell the asset class that has outperformed (selling high) and buy the asset class that has underperformed (buying low).

One of the disadvantages of rebalancing is that sometimes you cut the legs out from under the asset class before it has finished its bull run. Many studies have shown that the optimal periodic rebalancing schedule is two years. But again, most investors would not fair well employing a two year rebalancing schedule. It's too long psychologically. We're short-term thinkers, generally.

Another disadvantage with periodic rebalancing is that sometimes it's not needed. If your asset allocation has only drifted to 61/39, does it make sense to incur transaction costs and potential tax liabilities to bring that back in line? No.

An alternative to periodic rebalancing is to rebalance any time your allocation drifts to a certain threshold. Perhaps that threshold is 5 per cent. That could happen in a week, or it could take a year to happen. The advantage with this method is that you are constantly buying low and selling high and potentially taking advantage of opportunities often in a whipsawing market. In calmer markets, you may not be touching your portfolio for some time. The disadvantage is that it requires more attention.

If you are using a financial adviser, you're probably using a hybrid of the two approaches. You're probably getting a portfolio review once a year if you're using a buy-and-hold approach with your investments, and during that review, if the allocation is off enough, your adviser will recommend a rebalance.

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There is no perfect solution. Once again, your rebalancing plan only works if you can stick with it. For some people, they choose not to look at their portfolio too much and a periodic plan would work best. Others are more involved and choose to rebalance based on threshold deviations.

Theory is great, but it offers little comfort in practice. It's important to balance the two in order to be a successful investor.

Preet Banerjee is a senior vice-president with Pro-Financial Asset Management. His website is wheredoesallmymoneygo.com.

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