In a previous article, I described the benefits of allocating your investment dollars among assets in different, non-correlated asset classes (for example, stocks, bonds, real estate, precious metals, etc.). This is easy and convenient now that there are exchange-traded funds available to everyone for all of these assets. It is easy, convenient and inexpensive to create a diversified portfolio within a regular stock brokerage account.
In that article I mentioned the additional benefit to be obtained from periodically re-balancing that diversified portfolio. That’s what we’ll discuss today.
What Does it Mean to Re-balance a Portfolio?
Re-balancing a portfolio means making periodic adjustments to the size of your position in each asset, to return them to the proportions that you started with. This is much more powerful than it may sound.
Let’s say that you have $100,000 to invest. You select five different, non-correlated assets. You allocate a certain amount of money to each one. This could be equal amounts, or the amounts could differ from one to the other, but you select an amount for each one to balance your risks as you think best for you. For simplicity, in the example below we’ll use equal amounts. You buy $20,000 worth of each of the five assets.
In a year, all five of the assets will have either produced cash flow in the form of dividends or interest or lost money, but each will have changed in price from the starting point. We’ll credit the accumulated cash flow for each asset, if any, to that asset’s allocation. We’ll then calculate our new portfolio balance, valuing each asset at its current market value and adding in the accumulated cash flow.
If a particular asset gained interest, it will now be above the original 20% allocated. If the asset lost money, it will be below the original 20% allocation. The goal of re-balancing your portfolio is to bring all assets back to the original allocation amount to stay within your risk parameters.
Re-balancing now consists of the following steps:
Divide the new portfolio total value by five, to arrive at the number that now represents 20%.
Identify which assets now have a value that is greater than that 20% value.
Sell a portion of each one of those outperforming positions so that the value of each now equals 20% of the new total value.
The remaining assets are the ones whose balances are less than 20% of the new total. Use the cash generated in step three to increase the size of those positions so that they reach 20% of the new total. The available cash will be exactly enough to accomplish that.
The point of performing this re-balancing is to take profits on those assets that have outperformed. We know that in some future year, it will be those assets’ turn to be the losers in the group. When that occurs, our losses on those will be smaller because we will have already reduced our positions. On the other hand, this year’s losers will very likely be winners in a future year (if we have chosen our assets carefully). When that happens, our profit on them will be larger, because our positions will have been increased.
It may seem strange, but periodic re-balancing increases the return on virtually any portfolio. The less correlated the assets in the portfolio are, the more re-balancing improves the overall performance. As long as each of the assets performs differently form the others, the re-balancing process forces us to buy low and sell high.
Below is a graphic illustration. The following chart shows the price changes over time of five different assets. The bottom of the diagram shows the cumulative profit on the portfolio as a whole, excluding dividend and interest income to highlight the effect of re-balancing on the principal amount. The actual profit would have been somewhat higher than that shown.
In the bottom pane, each line represents the cumulative profit over a ten-year period that includes the crash of 2008. The red line is for a portfolio that was never re-balanced. The blue line represents a portfolio with the same assets and the same starting allocation amounts, re-balanced annually. In the period shown, the buy-and-hold portfolio returned about $93,000. Re-balancing increased the profit to over $115,000. This was a 24% increase in profits, with the exact same assets!
It turns out that as more time passes, the advantage of the re-balanced portfolio grows and grows. With a very long time horizon, twenty years or more, the re-balanced portfolio will grow many times larger than the buy-and-hold one.
In the last two articles, we’ve presented two simple yet very powerful principles of successful investing: diversification and re-balancing. A little time spent on these basic tasks will pay big dividends for decades to come.
Read the original article here - Re-balance a Portfolio to Increase Returns