WE DISCUSSED rebalancing between stocks, bonds and other asset classes earlier in this chapter. This might boost returns over the short run by forcing you to buy stocks during a market decline, which then sets you up nicely for the market rebound. But over the long run, this rebalancing will likely crimp returns because you’ll often be cutting back on stocks. Instead, the main reason to rebalance between asset classes is to control risk by keeping your portfolio’s asset allocation in line with your target portfolio percentages.
By contrast, rebalancing within asset classes has the potential to boost returns. Suppose you own the eight-fund portfolio described earlier, which includes 20% in U.S. large-cap stocks, 6% in U.S. small-cap shares, 22% in developed foreign stock markets and 7% in emerging stock markets. Let’s also assume that these different parts of the global stock market generate similar long-run returns.
As long as these various market sectors don’t notch the same return every year, you should bolster your long-run returns if you follow a strategy of regularly rebalancing back to your target percentages. Let’s say U.S. large-cap stocks outperform U.S. small-cap shares this year, but next year U.S. small-cap stocks make up the ground lost. If you rebalanced at the end of this year, you should boost returns next year by making sure you have a healthy weighting when small-cap stocks outperform. You can see how this works mathematically in the chapter on investment math. Over long periods, rebalancing among stock market sectors might add around half a percentage point a year to your return.
This comes with a few caveats. You need to make sure that any performance advantage isn’t eroded by investment costs and taxes. In addition, while rebalancing sounds simple, it can be tough in practice. It means bucking the crowd and buying into parts of the market that others currently loathe—not an easy thing to do.
Next: Step 4: Investments
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