If there was ever a right time to test the theory of rebalancing, it was the China-induced August selloff. Many financial advisors are using recent stock market volatility as a life lesson in why rebalancing matters.
Rebalancing — the constant portfolio monitoring that restores asset classes to their target allocations by selling assets that have appreciated and adding to those that have declined — is at its core a risk-minimizing strategy. It's not meant to increase returns, though it has proved to do that, too.
"People don't want to rebalance when the stock market is doing well," said Colleen Jaconetti, a senior analyst with Vanguard's Investment Strategy Group. "But what if the stock market did drop 20 percent and they had not rebalanced?"
The risk, then, noted Jaconetti, is that by letting the equity portion ride, investors may end up with a much higher allocation to equities than they are comfortable with.
When a correction hits, those investors may find that they don't have the risk tolerance they thought they did, "and they abandon their strategy altogether," she said.
Rebalancing is the not-too-thrilling cousin of asset allocation, the act of deciding which asset classes to include in your portfolio and in what proportions, so they maximize returns for the level of risk you're willing to take on. Some observers believe that asset allocation — not stock-picking smarts — largely determines a portfolio's return, so it's important to pay attention to it.
Another reason for rebalancing is that it's unwise to sell plummeting securities in a downturn, even if there's a need to raise cash. Doing so locks in losses. Rebalancing ensures that there will always be some assets that are up, said certified financial planner Don Roy, branch owner of New England Wealth Advisors.
"We want no client of ours in a situation where they don't have an asset they can sell when they need money," said Roy.
So does rebalancing work? In a study published in May 2014, in the "American Association of Individual Investors Journal," editor Charles Rotblut set out to answer that question and he found that, yes, it does.
Rotblut tracked how three different investor behaviors would impact a moderate allocation portfolio (defined as one with 70 percent in stocks and 30 percent in bonds) since 1988.
First was a portfolio that was rebalanced each time its allocations were off by 5 percent or more from its targets. Next was a non-rebalanced portfolio. And third was a portfolio where an investor panicked and got out of stocks each time the Standard & Poor's 500 Index fell at least 20 percent — most investors' definition of a bear market. Rotblut used all Vanguard funds in his study.
The rebalanced portfolio outperformed the other two. What's more, that portfolio also experienced less volatility than the non-rebalanced portfolio and about the same level of volatility as the sold off one, which surprised Rotblut.
"Although the goal of pulling out of the market was to stop the pain of the bear markets, over the last 26 years, an investor would have experienced the same level of volatility by simply sticking with stocks and rebalancing as necessitated," Rotblut wrote.
There are two reasons for the higher returns. First, by keeping investor panic at bay, rebalancing lets a portfolio ride out a selloff. It also works because "you are selling gains and buying investments that have gone down," said Janet Brown, president of FundX Investment Group and editor of the "NoLoad FundX" newsletter.
While rebalancing promotes good investor behaviors, it runs counter to investor psychology. Rebalancing means selling winners and buying losers—something that is exceedingly difficult for many investors to do.
That's why observers such as Jaconetti of Vanguard say putting a barrier between yourself and the investment decision can be helpful. "That's a huge area where advisors can add value by removing the emotion of selling [winners]," she said.
There are several ways to rebalance. One calls for rebalancing at particular points in time, perhaps quarterly, semiannually or annually.
A more common method calls for establishing thresholds. If any asset class is off by a certain percent of its target, typically between 5 percent and 10 percent, investors should rebalance.
Vanguard's Jaconetti prefers a combination of both methods, as outlined in a paper she wrote with several Vanguard colleagues (to download the study, click here).
She recommends that investors choose one or two dates each year to check their portfolios. If their target allocations are off by 5 percent or more, they should rebalance. "That's when the benefit of rebalancing outweighs the cost," she said.
When asset classes veer off their targets to a lesser degree, the cost of rebalancing — big-ask spreads and commissions — is too high to gain any benefit. By the same token, when allocations are 10 percent or more off their targets, "then you get to the point where you're taking on a lot of risk," Jaconetti said.
To minimize the cost of rebalancing, Jaconetti recommends using new cash to create the desired effect. Direct any new investments toward the asset classes that have declined until your portfolio is back in balance. After that, spread out your money as before.
While rebalancing is a wise move, it might stick you with taxes. After all, you are selling gains. If that's the case, identify losses that you might sell to offset those gains (after the August selloff, that task became easier).
Or establish wider bands in taxable accounts — say, 8 percent instead of 5 percent — so you'll be rebalancing less frequently. Gains, however, aren't a concern in retirement accounts, so you can be more vigilant.
—By Ilana Polyak, special to CNBC.com