When your portfolio is put together, allocations are chosen based on your goals, risk tolerance, and other elements of the financial planning process. Over time, as the market moves and current events take place, your portfolio naturally moves with it. Rebalancing is the process of restoring your portfolio to its original balance, thereby remaining in line with your risk tolerance and desired outcomes.
Take this example from Morningstar:
Let’s say that you put $10,000 in T. Rowe Price New Income (PRCIX) and $10,000 in T. Rowe Price Growth Stock (PRGFX) in January 1997. At the end of 2006, you had to congratulate yourself. Your $20,000 investment had turned into more than $41,000.
Credit a lot of that success to the stock fund. Your position had grown to more than $24,000 at the end of the period. T. Rowe Price New Income, while no slouch itself, was just $17,271.As a result of that outperformance, T. Rowe Price Growth Stock soared to roughly 60% of your portfolio in late 2006. You decide not to mess with its winning streak.
By late 2008, however, you would’ve gone from patting yourself on the back to kicking yourself you know where. Your portfolio lost more nearly 20% over the two previous years. The culprit? T. Rowe Price Growth Stock, which, like most stock funds, lost nearly two thirds of its value in that two-year period, a vicious bear market for stocks. T. Rowe Price New Income, on the other hand, made money during that period.
If you had rebalanced your portfolio at the beginning of 2007, re-establishing equal positions in the funds, you wouldn’t have lost half as much during that year. Rebalancing would have protected a sizable chunk of the gains you made with T. Rowe Price Growth Stock.
Since we can’t tell the future, we don’t know what will perform well this year, next year, or 10 years down the road. By regularly rebalancing your portfolio, your risk is better managed, and diversification can better protect you as well. If you’d like to learn more about how the team at McCabe & Associates assists our clients in managing market risk, please contact us.