Well, it’s that time of year again. Drag out the tree, string up the lights, hang the stockings and rebalance that retirement account! Wait, what?!? Yep, that’s right, the good ole’ annual rebalance is something that should be a staple to any active retirement plan but, sadly, is one of the critical pieces missing from most end of the year to do lists. Let me explain.

Just as it sounds, a rebalance of an account is a way by which you simply adjust a portfolio to make sure it still is in line with your overall risk tolerance and longer term objective. Let’s say, for instance, that your desired allocation is a 60 / 40 mix between stocks and bonds. You’ve managed to save few hundred thousand dollars this year. While the stock index has managed a decent return, many bond funds have stunk it up. For general discussion purposes, let’s say that to begin 2016 your 60 / 40 allocation in your $200,000 401k or 403b looked a bit like the following:

Stock Mutual Funds: $120,000 (60%)
Bond Mutual Funds: $80,000 (40%)

In addition to your bi-weekly contributions, your stock funds managed to gain an additional 5% but your bond funds lost 2%. Leaving contributions out of it for now, the rise and fall of the investments results in the following:

Stock Mutual Funds: $126,000.00 (+6%)
Bond Mutual Funds: $78,400.00 (-2%)

This equates to a total portfolio value of $204,400. Sure, your net return of 4.4% is better than a hunk of coal, but let’s now take a look at the allocation of this portfolio.

Total Account Value: $204,400.00

Stock Mutual Funds: $126,000 (62%)
Bond Mutual Funds: $78,400 (38%)

While it is subtle, the result of this performance is that you now have a larger weighting in stocks than your overall allocation or risk tolerance dictates. Sure, this few % points difference isn’t all that much at the present time; however, over the years, this subtle shift can result in a massive overweight or underweight of one’s personal long- term allocation.

Some of you will remember the bumper years of the late 1990s. The dotcom bubble took stocks on a rocket ride to new highs that wouldn’t be seen again until almost 20 years later. While most passive investors enjoyed the run up, they also experienced the pain of the other side once the bubble burst. If an annual rebalance would have been part of the strategy, much pain and discomfort could have been avoided.

Let’s look at a more extreme example. Let’s say in a given year stocks advance 30% and bonds advance 5%. The following year these same stocks advance another 20% while bonds advance 4%. The run is only the end of the next inevitable bubble and stocks subsequently tumble 40% while bonds act as a safe haven and end up 10%. Let’s review what happens between two different portfolios invested in the same areas; one pursues an annual rebalance, while one rides the rollercoaster of the markets.

Here are the hypothetical returns for our example:
Stocks Bonds
Year 1 30% 5%
Year 2 20% 4%
Year 3 (-40%) 10%

Portfolio 1 does not rebalance and has a 60/ 40 mix with a balance of $200,000. The following returns apply.

Beginning Allocation Stocks – $120,000 Bonds – $80,000 Total: $200,000

Year 1 30% – 156,000 5% – $84,000 Total: $240,000

Year 2 20% – 187,200 4% – $87,360 Total : $274,560

Year 3 40% – 112,200 10% – $96,096 Total: $208,296

The total return after 3 years in this portfolio is $8,296.00 or a little more than 4%. Now let’s look at a portfolio that pursues an annual rebalance.

Beginning Allocation Stocks – $120,000 Bonds – $80,000 Total: $200,000

Year 1 30% – 156,000 5% – $84,000 Total: $240,000

Rebalance Total $144,000 $96,000 Total: $240,000

Year 2 20% – $172,800 4% – $99,840 Total: $272,640

Rebalance Total $163,584 $109,056 Total: $272,640

Year 3 40% – $98,150.40 10% – $119,961.60 Total: $218,112

A simple annual rebalance each year resulted in a portfolio gain of $18,112.00 or a total return since inception of 9%.

This little trick saved our annual rebalancer a cool $10,000 in just 3 years. Sure the numbers in our example may be a bit extreme, but it is just these extreme circumstances that seem to come along that make this strategy such a must.