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When Should I Rebalance?

I'm not very lucky -- but at least I know it. I don't play the lottery, I look both ways before crossing the street, and I refuse to go skydiving. But I do get nervous from time to time when I have to rebalance my portfolio. With my bad luck, I'd be the guy to pull away from stocks the day before world peace was announced. To minimize the chance of such a blunder, I've often wondered how frequently I should rebalance.

In the past, I've used the New Year as the rebalancing trigger. Once a year, I take a quick look at my Roth IRA, then split my contribution so that my portfolio is rebalanced to the original asset mix. To test this technique, I recently pulled up 10 years of returns on index funds from Yahoo!'s helpful finance site. For the stock fund, I chose Vanguard's Total Stock Market Index (FUND: VTSMX  ) and for the bonds, Vanguard's Long-Term Bond Index (FUND: VBLTX  ) .

(Why Vanguard? Because I'm cheap, and their data went back to 1996. A decade isn't an amazing data set, but the last decade does contain a fair share of booms and busts -- exactly what I was trying to test.)

For starters, I arbitrarily selected a 70/30 stocks-to-bonds asset allocation, which should be about right for most young investors. Assuming a $10,000 investment in 1996, the basic portfolio returned $22,771 after 10 years, with no rebalancing. That's a not-too-shabby 8.37% annual rate of return. The graph of daily returns showed me that the asset allocation varied greatly from the targeted 70/30 split, as stocks and bonds took turns outperforming each other.

For the next run, I rebalanced the portfolio at the end of each year, buying or selling enough of the index funds to return to the 70/30 split. In this case, the portfolio returned $23,279, or 8.61% annually. This performance included the cost of trading, assumed to be $8 per buy or sell order. (If you haven't figured out how to trade for less than $10, stop reading this article and visit our Broker Center.) Amazingly, rebalancing beat the original portfolio, even after trading costs. And within a Roth IRA, taxes don't change the results, either.

If rebalancing annually works well, rebalancing quarterly or monthly must be even better, right? (My father uses a similar theory when applying lighter fluid to the grill.) Not so fast -- rebalancing provides diminishing returns on additional efforts, partly because of the increased trading costs. For my test portfolio, quarterly rebalancing yielded an 8.37% annual return -- the same as no rebalancing whatsoever -- while the return for monthly rebalancing sank to 7.88%. Worse yet, that strategy racked up more than $2,016 in trading costs! Ouch.

For my last test run, I set different rules. Rather than worrying about the calendar, I rebalanced only when the original asset allocation was broken by more than 10%. In other words, when stocks exceeded more than 80% of the portfolio, I sold enough of the stock index fund to return to the 70/30 split. The results were remarkable. This portfolio beat the original by more than $2,000, yielding 9.28%. It even beat a 100% stock portfolio, while also sporting lower variability and risk.

Better yet, my hypothetical broker went broke. The portfolio rebalancing trigger was only hit three times -- in January 2000 it sold stocks for bonds, and in March 2001 and October 2002 it sold bonds for stocks. That's a total of six trades, or $48 in commissions, over an entire decade.

Of course, I have more testing to do, but the results continue to point in the same direction: Rebalancing works best when it is linked to portfolio performance, not date. I tested lower rebalancing triggers (1%, 3%, etc.) and found that the trading costs creep up quickly, but results don't improve much. For now, I'm going to stick to the 10% rule. The online account on my real portfolio is kind enough to display allocation percentage, so from now on, when an asset creeps outside of the 10% fence, I'm ready.

And since I'm unlucky, I know to stick to the rules. The rebalancing trade occurs at the 10% trigger -- not at 9.95%, not at 11.4%, and certainly not because of where I think the market is heading. So think about rebalancing, and how it can work for you. It isn't about trying to time the market; it's about letting market results dictate action.

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Fool contributorRyan Poppledoesn't own any of the funds mentioned in this article. He can't rely on luck for his investment results, as he shares his home with two black cats. He welcomes your feedback atryan.popple@gmail.com. Yahoo! is a Motley Fool Stock Advisor pick. The Fool has adisclosure policy.


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