Rebalancing is a portfolio management tool designed to get your portfolio back to your original target. Why? Because with time your allocation drifts and you take on a different risk profile with a different portfolio allocation.
Let’s assume you are not investing in individual stocks (which may go to zero for a complete loss). Instead you invest in index funds (which suggest all the companies in the index would need to go to zero for you to experience a complete loss).
Let’s also assume you have a global asset allocation with indexed exposure to many different asset classes.
What happens when, say for example, the European indexes decline in your portfolio and you have a pre-determined regime to rebalance?
First, you already have the money invested in the portfolio, so this summary is not addressing dollar cost averaging.
Second, rebalancing means selling off a portion, or taking a haircut on the allocation that is over target, to bring the over target allocation back to the target allocation of that asset class allocation.
Third, rebalancing also means buying into the asset class that has declined … in this example, this would mean buying into the European decline.
Remember the old saying, “Buy low, Sell high?” Well rebalancing is simply reversing those steps because you already have the assets invested.
PS. This principle would apply to any asset class that is “shunned” for the moment. What one gives up when indexing and rebalancing regime not applied is an ability to “buy low” when that opportunity presents itself. And notice that moment is precisely the time when emotion holds you back. Thus I’ll repeat … a regimen is needed to overcome counterintuitive emotions.
Rebalancing it related to diversification … and remember to it is not just about returns; it is also about balancing risk and volatility.
Here’s a short YouTube video that describes rebalancing
My blog above discusses how rebalancing keeps your portfolio closer to your risk targeted allocation. Buy and hold may have risk elements grow over time (for example, stocks tend to gain more than bonds so, over time, your risk would creep higher with more value in stocks). This article talks about whether one might get a return bonus … a completely different reason than what I discuss above … but, I share it here to be sure reader’s aren’t confused by these two different objectives: 1) Return boost (linked article) vs 2) keeping risk within what you are comfortable with (blog points above)
Here is a great comparative article on the difference between rebalancing based on Time Horizons Vs Tolerance Bands (PS. the method I use is the tolerance band)