Most people know they should pursue a balanced diet, and most investors realize they should rebalance their portfolios periodically. Too many people, however, fail to do either, says Bill Swerbenski, director of the Schwab Center for Investment Research.

Studies by the San Francisco-based centre show that if inves-tors don’t rebalance their portfolios periodically, their investment strategy can start to drift, changing their risk level unwittingly. In fact, if investors started the bull market in October 2002 with a 60/40 allocation to stocks and bonds but never rebalanced, their equity allocation would have grown to 72% of the portfolio four years later, leaving bonds with only 28%.

Rebalancing is a time-tested risk-control mechanism that may sound logical in theory, but is often difficult for investors to practise. That’s because it usually involves trimming winning asset classes, which goes against most investors’ instincts, Swerbenski maintains, but it’s important to do anyway.

Investors could rebalance a portfolio at different frequencies, the most common being monthly, quarterly and annually. At such intervals, rebalancing is often mandatory. Alternatively, investors could rebalance only when a trigger is exceeded, such as when the weighting of a particular category drifts by more than 5% from its target (a.k.a. “threshold” rebalancing). Some rebalance according to broad asset class weighting, while others take into consideration the weighting of growth and value investment styles within an asset class.

Once investors jump the psychological hurdle of selling their hottest winners and pouring that money into what may be their weakest-performing asset class, they’ve won more than half the battle. Indeed, Schwab research suggests there’s really not much variation among different rebalancing techniques. Simply put, it is less important how you rebalance than that you do rebalance, Swerbenski says.

Steven Weinstein, president of Altair Advisers LLC, a Chicago-based investment advisory firm, conducted a study using a portfolio consisting of 60% equities and 40% fixed-income investments diversified over various asset classes and investment styles. He chose an annual, mandatory rebalancing schedule, reflective of annual client meetings and a time frame that is long enough to minimize taxes and transactions costs.

Unlike many other studies, his research analysed the results of rebalancing on portfolio performance, both before and after taxes. He first examined a taxable, diversified portfolio during the 1980–2002 period, which was primarily a bull market for all asset classes.

Next, Weinstein focused on the three longest and worst bear markets between 1926 and 2002. The results from the different sets of market conditions, he says, demonstrate that rebalancing makes sense whether the economy is in the throes of a terrible recession or in the midst of a great bubble. In both instances, rebalancing lowered risk and improved risk-adjusted performance as measured by the Sharpe ratio. Rebalancing during volatile markets actually increased returns slightly.

Some investors fear the tax liability generated by rebalancing will wipe out its benefits. Weinstein found that although taxes mitigated the benefits, taxes did not eliminate the benefits completely.

But some researchers say rebalancing too frequently can harm a portfolio. In a recent study, New York State University professor David Smith suggests delaying the process by as long as four years. In the case of threshold rebalancing, he recommends waiting at least until relative weights become 5% or more out of alignment.

Between 1926 and 2003, the optimal rebalancing intervals were in the 39- to 44-month range, whereas the poorest results were achieved through rebalancing either quarterly or semi-annually, Smith’s research shows. When transaction costs and taxes are considered, the underperformance eats up too much of the gains, he maintains.

Markets tend to trend in the short run before reverting to the mean. Smith concludes that sitting tight for up to three or four years allows a portfolio to ride the wave longer and capture more upside, albeit with additional risk. IE