Portfolio rebalancing

April 1, 2003
In last month's column we discussed why even long-term investors should be concerned with market timing. This month, we will focus on a particular strategy that requires evaluation only once every year — portfolio rebalancing.

Marvin Appel, MD., PhD & Brian Hufford, CPA, CFP

In last month's column we discussed why even long-term investors should be concerned with market timing. This month, we will focus on a particular strategy that requires evaluation only once every year — portfolio rebalancing.

When you start investing for the future, you decide upon the right mix of different investments that suit your anticipated financial needs and your temperament. Rebalancing your investments simply means periodically restoring your original mix of investments. For example, if your original goal was to be half in stocks and half in bonds, and your stocks have a very strong year, you would end the year with more than half of your assets in stocks. Rebalancing requires moving some of your stock assets into bonds to restore that 50/50 mix. Your goal in re-evaluating your investments each year is to make sure your holdings bear the same relationship to your goals as they did when you started your investment plan.

Why is this an issue? Because, over the long term, certain investments will likely outperform others and become a disproportionately large part of your holdings. When this occurs, your risk rises, approaching the risk of your largest single holding.

As an example, from 1982 through 2000, stocks did very well and far outpaced bond, cash, or real estate investment returns. If your original strategy in 1982 was a 50/50 mix of stocks and bonds, by 2000 your stock weighting would have increased from to almost 75 percent. When the bear market struck, you would have been exposed to the risk of an all-stock portfolio.

Does this increase in risk make a difference if it brings a greater return? It depends. If you can handle the risk psychologically, then by all means go for the profit. But you must set your retirement savings goal high enough to provide a margin of safety.

Investors who believed during the peak years that they had saved enough got into trouble unless they locked in their gains. But this can be very hard to do during market peaks. In March 2000 alone, the S&P 500 gained almost 10 percent. Who could resist hanging in for more of the same later in the year? Since bear market declines of 30 percent have in the past recurred every several years, you should not retire on a portfolio mostly in stocks unless you are prepared for the market to lose 30 percent beginning the day you retire. (Of course, future bear markets can be worse than that, or more frequent. History is only a guideline, not a guarantee.)

In past columns, we presented a historically low-risk, diversified portfolio: 20 percent S&P 500 index fund, 10 percent small-cap value, 20 percent real estate investment trust, 30 percent intermediate term corporate bond and 20 percent money market. Such a portfolio acquired at the beginning of 1982 with no rebalancing would have earned 10.7 percent per year by 2002. During that period, the greatest loss of principal in any calendar year would have been 7.5 percent in 2002.

However, if you had rebalanced annually, the annual gain would have been a tad lower at 10.5 percent per year. However, the risk would have been much lower, with a worst-year loss of only 2.4 percent (in 2002).


If your investments are in taxable accounts, rebalancing may increase your tax costs. Depending on normal year-to-year market fluctuations, this impact should be small, but you should verify the costs each year in your individual situation. Transaction costs may also be a factor. Individual mutual funds may charge redemption fees, and even discount brokerage costs can be significant. Again, as with any investment decision, investigate the costs before taking action.

The important message is that it is not necessarily safe to place your investments on auto-pilot. Annually reviewing and rebalancing your investments can keep you on the right road to financial security.

Dr. Marvin Appel is CEO of Appel Asset Management. He holds a degree in biochemical sciences from Harvard College and earned his MD in 1991. He is coauthor of Systems and Forecasts. Contact him at (516) 487-7146 or [email protected]. Brian C. Hufford, CPA, CFP, is president of Hufford Investment Advisory Programs, LLC, and Hufford Financial Advisors, companies dedicated solely to helping dentists secure solid financial planning and safe investment strategies. He can be reached at (317) 848-4987.

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