Let's say you have a portfolio with a target allocation of 50 percent in U.S. stocks and 50 percent in international stocks. Then U.S. stocks rise 10 percent and international stocks fall 10 percent over time.
In this scenario, you would have a portfolio of 55 percent in U.S. stocks and 45 percent in international stocks. So you'd need to sell U.S. stocks and buy international stocks to rebalance the portfolio to the allocation you originally wanted.
"The nice thing about rebalancing is that it is simple to understand and helps investors stick to their plan regardless of what the market does," said Charles Rotblut, vice president of the American Association of Individual Investors and editor of the AAII Journal.
Rotblut conducts an on-going analysis of the benefits of rebalancing. He has tracked the performance of hypothetical portfolios based on the AAII's moderate asset allocation model since 1988. The model portfolios allocate 20 percent to large-company stocks, 20 percent to midsize-company stocks, 10 percent to small-company stocks, 15 percent to international stocks, 5 percent to emerging market stocks and 30 percent to bonds.
From 1988 to 2015, the rebalanced portfolio generated an annualized return of 9.1 percent while the portfolio that wasn't rebalanced had an annualized return of 9.3 percent.
Though the returns in both portfolios were similar, the rebalanced portfolio did so with 12 percent less volatility. The rebalanced portfolio's largest annual loss was 26.9 percent versus 32.8 percent for the portfolio with no rebalancing.
"You look to rebalancing as a way to minimize risk, not maximize returns," said Colleen Jaconetti, a senior investment analyst with the Vanguard Group.
A 2015 Vanguard study by Jaconetti and two others analyzed the impact of rebalancing on the performance of several hypothetical portfolios from 1926 through 2014. Vanguard analysts concluded that "just as there is no universally optimal asset allocation, there is no universally optimal rebalancing strategy. The only clear advantage so far as maintaining a portfolio's risk-and-return characteristics is that a rebalanced portfolio more closely aligns with the characteristics of the target asset allocation than with a never-rebalanced portfolio."