The Virtues of Re-Balancing a Portfolio
Remember that in year two the stock prices dropped back to their original value, meaning they were cut in half after doubling in year one. So, our $31,250 worth of stock dropped by $15,625. The other three assets were unchanged once again. With our portfolio having been rebalanced though, we are not back to where we started – we have a net gain of $9,375 for the two years. We gained $25,000 on our stocks the first year; then we “gave back” only $15,625 in year two, leaving us with a net profit.
The re-balancing, by itself, created a net return of 9.375% over two years compared to a zero return for buying and holding.
Setting up for year three, the portfolio now is worth $109,375. Twenty five percent of that is $27,344. Our stocks now are worth $15,625, which is less than $27,344. Each of the other three assets is now worth $31,625, which is more than $27,344. We now transfer $31,625 – $27,344, or $3,906, out of each of those other assets. This gives us $11,718 in cash with which we can buy more stocks and everything is equal once again. Rinse and repeat.
This example is very simplified. But the mathematical fact is that as long as the various assets in a portfolio change in value at different rates and as long as none of the assets ever becomes completely worthless, rebalancing adds to overall returns and always pays more than simply buying and holding the individual assets. As time passes and more up-and-down cycles occur, the difference between a rebalanced portfolio and one that is not rebalanced expands dramatically. This makes sense when we realize that re-balancing forces us to sell assets after they have risen in price and to buy them when they have dropped in price – in other words, to buy low and sell high.
This idea of strategic asset allocation and rebalancing can be a cornerstone of a solid wealth-building strategy and with this as a base we can build a comprehensive plan.
Russ Allen can be contacted on this link: Russ Allen