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Portfolio Lab: The Rebalancing Act

Jul 27, 2012
Ron DeLegge

What good is the perfect asset mix if it's never maintained?

Imagine designing and building a beautiful garden. You spend lots of time, money, and sweat making sure you have the right combination of plants and that they're correctly juxtaposed to one another. Now imagine never bothering to maintain that beautiful garden. What a complete waste!

Similarly, people spend time and money trying to build the perfect investment portfolio. But they overlook the maintenance part. And that's why periodic rebalancing is a must.

Financial research shows that all asset classes have eventual price mean-reversions in the long run. That means when an asset declines enough in price, it is more likely to experience high subsequent returns.

For example, when corporate bond (NYSEArca: LQD) prices fall and yields go up, the forward return on corporate bonds increases.

Along similar lines, when the S&P 500 Index (NYSEArca: SPY) falls in price, its dividend yield increases. And based upon empirical data, the subsequent returns on the S&P 500 tends to be significantly above average.

Price mean reversion in asset returns indicates that a disciplined rebalancing approach in asset allocation should enhance a portfolio's returns.

When is the ideal time to rebalance? Anytime a portfolio gets out of whack with its original objective or whenever a substantial change in asset values makes it necessary.

The objective of rebalancing is to take an investment portfolio back to its original target asset allocation. And if that original allocation objective has changed, then rebalancing will realign it in accordance with the new target.

Besides reducing risk, rebalancing can keep a person's investments correctly aligned with their investment goals. 

ETFguides Portfolio Report Card is a written report that helps investors to identify strengths and weakness in their investment portfolios. The Report Card also tells you whether your investment portfolio has too much risk.

I continue to use this same grading system to evaluate listener portfolios on my weekly radio program, the Index Investing Show, and it works.

Portfolio Lab is a column from ETFguide that focuses on investment ideas and tools to help individual investors improve their results.

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