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Finding the proper balance in life is vitally important to our happiness and success.   Sometimes we need to re-balance.

Too much of (just about) anything can turn a positive into a negative!

While I’m not much of an athlete, I do exercise regularly. My first workout program was simply jogging. Initially, I was lucky to finish a mile. I wasn’t overweight…just out of shape! Slowly but surely my endurance grew. It didn’t take long for my runs to reach several miles.

I tend to be a bit competitive (even with myself), and my runs grew longer…..and longer…..and longer. Eventually, my longest runs were 13.1 miles – a half marathon. These weren’t official races, mind you, just my workout for the day. In total, I was running between 20 and 25 miles a week. Not world class standards, but still a pretty long distance for a “casual” runner.

Eventually, though, my legs grew constantly tired and sore. A long run would require a couple of days to recover. The exercise had become a painful chore.

The lesson I learned was that I needed a proper balance to succeed. Skipping exercise wasn’t the answer, nor was running 20+ miles a week. I now exercise six days a week, but I’ve lowered my miles to about nine per week, with additional time spent on an elliptical for cardio work and weight lifting to build strength. My body feels much better and recovery times are much shorter.

The value of proper balance also applies to our investment portfolios! 

How portfolios get unbalanced

From other posts, you have a good idea of my investment philosophy. There is a specific balance between stock funds and bond funds, and between US funds and International funds. Over time this balance will get out of whack. Asset classes don’t rise and fall together. Sometimes stocks outperform bonds, or International stocks outperform US stocks.

For a simple example, imagine an investor beginning the year with 60% allocated to the Vanguard Total Stock Market Index Fund and 40% allocated to the Vanguard Short Term Corporate Bond Fund. As the year unfolds, assume that the stock fund outperforms the bond fund. By December of that year, the stock fund may have increased to 65% of the total portfolio value, while the bond fund has been reduced to 35% of the total value. No trades have occurred…the change in allocation is strictly due to the different returns in the two funds.

The dangers of being out of balance

So what’s the big deal if your fund allocation is off from the preferred percentages?  What are the possible consequences?

The primary danger of being out of balance is having a portfolio that doesn’t accurately reflect either your risk tolerance or return requirements.

Risk Tolerance

When you selected your target asset allocation, it should have been based on your personal risk tolerance. In essence, how much risk can you stand in your portfolio before you’d sell it all and run for the hills? Generally speaking, the higher the portion allocated to stocks, the greater the risk of loss. The positive side of the additional risk, though, is that stocks have historically gained more in value than bonds. Over time, more risk = more reward. We’d all love to have the higher returns that should come with an all stock portfolio, but few of us can tolerate the huge losses in market value that would sometimes accompany it.

As we saw in the example above, over time an allocation can shift from your personal preference into one that is significantly riskier. That unintended shift, if left unchecked, may lead the unsuspecting investor into significantly higher losses in the next market downturn; losses which may well lead them to selling in a panic. There are many stories of improperly allocated investors who bailed from the market in the 2008 downturn. Some of those same investors then missed the terrific market rebound starting in 2009, fearfully sitting on the sidelines shell-shocked from their losses the year before.

Rebalancing the portfolio to return it to the predetermined asset allocation removes the added risk.

Return Requirements

If one side of the coin is risk tolerance, the other side is return requirement. We’ve already established that more risk = more return. The opposite is also true: less risk = less return.

Just as a portfolio can become too heavily allocated to stocks, it can also become too lightly allocated to stocks when the market suffers a large downturn. Think of it as being the opposite of the example given earlier. Over time a 60%/40% portfolio can become 40%/60% if stocks crash and bonds rally (which is often the case when stocks fall sharply).

Since the portfolio has less risk (for example, 40% stocks instead of 60%) it will most likely have a lower return (remember: less risk = less return). The long term effects of a 40% equity position versus the desired 60% equity position has been around 1% in annual return. One percent may not sound like much, but over 30 years it reduces your total return by nearly a third! This reduction may mean the difference between having enough money in retirement or going broke!

The benefits of rebalancing

As we’ve seen, rebalancing brings the portfolio allocation back to an acceptable level of risk and prevents it from taking on too much risk for your comfort. It also increases the odds of getting the returns you may need to retire with dignity and self-sufficiency.

Rebalancing also forces the investor to buy low and sell high. By selling the sector that has done well (and is thus over-weighted) the investor is locking in some of these gains. By taking the proceeds from that sale and buying the sector that has under performed, the investor is buying when prices are lower. Both of these are positive long term steps, but often run counter to human nature (we desire to buy more of what’s done well and sell the “dogs” of the portfolio).

Studies have shown that regular re-balancing offers a higher return and lower risk versus leaving the portfolio unbalanced.

One word of caution: If you re-balance within a taxable account, the sale of securities will be a taxable event. For this reason, rebalancing should generally be performed inside of a tax preferred account (such as an IRA or 401k). Be sure to understand the tax implications if you sell a security in a taxable account. If it’s being sold at a loss, it may be fine to sell and realize a tax savings. However if it’s being sold at a gain, you will have to recognize the income. Consult a tax adviser if you’re unsure of the tax cost or implications.