A year ago when the markets were all setting new highs, people were asking what they should do with their retirement portfolio. I answered, “Rebalance.” Now that the market is setting new lows, I get the same question, and my response hasn’t changed.

Rebalancing requires discipline. You set a target asset allocation for your investments and then periodically buy and sell different investments to stay focused on your objective. Without rebalancing, those categories that do well may continue to grow as a percentage of your portfolio until they significantly underperform the markets. The ones that do the best often bubble and finally burst. Rebalancing avoids this needless anguish.

Investing in an S&P 500 index fund does the opposite of rebalancing. The S&P is a capitalization-weighted index. A stock’s capitalization is the total outstanding shares multiplied by the stock’s current price. Therefore, those stocks whose price has appreciated comprise a greater share of the index. The S&P automatically increases its holding in stocks that have gone up and decreases its holdings in stocks that have gone down. This is the opposite of what you want.

Having the right asset allocation in the first place is an essential part of rebalancing. Rebalancing back to an S&P 500 allocation misses the emphasis on value stocks that will help your portfolio returns.

Stocks that have decreased in price have a lower price-to-earnings (P/E) ratio. They are called “value stocks.” These stocks on average do better than growth stocks. But capitalization-weighted indexes such as the S&P 500 miss this method of boosting returns.

Several new investment products tout what is called “fundamental indexing.” They set target allocations based more on earnings than price and therefore gain a value tilt. This is a good strategy, but the funds using it are currently charging higher fees and expenses than necessary. As expenses on these funds drop, they may prove to be a better investing strategy. In the meantime, you can develop a less expense asset allocation with the same value tilt simply by putting part of your asset allocation into a value fund. Adding a large-cap value fund to your S&P 500 fund will emphasize those stocks with a low P/E ratio. A value fund will sell stocks whose price has appreciated enough that they are no longer considered value. And it will buy stocks whose price has dropped enough for them now to be considered value.

Portfolio construction begins with the most basic allocation between investments that offer a greater chance of appreciation (stocks) and those that provide portfolio stability (bonds). Decisions made at this level are the most critical in determining how well behaved your portfolio returns will be.

Even if you are creating a very aggressive portfolio, including some fixed-income investments actually increases returns. Stable investments provide some cash on the sidelines, and having cash to buy stocks after a market correction both boosts as well as evens out your investment returns. Thanks to the effect of compounding, smoother returns produce better returns.

Periodic rebalancing is the simplest and most common method. Waiting for an asset category to exceed some threshold and then bringing the allocation back within some tolerances seems to produce slightly better returns and lower volatility. Although different ways of rebalancing produce somewhat variable results, the method you use is not as important as committing to a regular rebalancing plan.

Crestmont Research studied the difference in returns between rebalancing every year versus every two years in varying types of markets. They found that in secular bull markets, rebalancing less frequently had a slight 0.3% annualized advantage, but in secular bear markets, rebalancing more frequently had a more significant 1.3% advantage. Another study of the same time period verified smaller advantages for even more frequent quarterly and monthly rebalancing. And a study of the Yale endowment attributed 1.6% of its portfolio returns to rebalancing.

Making an extra percentage point a year is significant. The Crestmont study concluded, “In choppy and volatile markets, a more frequent rebalancing approach can add significant additional return to an investor’s portfolio. Based upon recent secular market history, the risk (cost) of more frequent rebalancing in secular bull markets is far less than the opportunity from more frequent rebalancing in secular bear markets.”

Crestmont’s observation is true because a secular bear market does not simply go down every year. Rather these markets often swing up and down wildly. The Crestmont study analyzed the secular bear markets from 1966 to 1981 and concluded that rebalancing more frequently made the difference between experiencing positive or negative returns.

Keep in mind what rebalancing in a secular bear market means: buying stocks after they have gone down and selling stocks after they have gone up. Probably the point at which more frequent rebalancing pulled ahead the most was 1973 and 1974 when the market dropped 17% and then 28%, and more frequent rebalancing meant putting more money back into the markets. Then in 1975 and 1976 when the market rebounded 38% and 18%, respectively, it provided better results.

Rebalancing is as daunting as putting more money into the markets now after our recent declines. But it is also as prudent as taking profits off the table a year ago when the market was setting new highs. Rebalancing, always a contrarian move, helps investors make those emotionally difficult but safer and more profitable decisions.

Portfolio design and rebalancing is both a science and an art. It may be helpful to understand the physics of why a spinning ball hooks and bends. But when you are playing golf or soccer, it is the execution and follow-through that produces the desired outcome. Knowing that rebalancing boosts returns is useless unless you as the investor have the time, discipline and nerve to follow through and actually strike the ball.

Untended portfolios can quickly become more volatile. Thus frequent watching of a portfolio is required even if frequent rebalancing is not the best methodology. Watching your portfolio every day and choosing strategic inaction allows you to seize the day when the portfolio is significantly far enough out of balance to warrant action.

How frequently you need to water your garden is totally contingent on current weather conditions. Similarly, when you should rebalance your portfolio depends more on what the markets are doing than the calendar.

Rebalancing need not trigger a taxable event. You can do it when you are adding to your portfolio or during retirement when you are making withdrawals. Another way of rebalancing without triggering capital gains is to make the changes in your traditional or Roth retirement accounts. You can also pay dividends and interest in cash rather than reinvesting them. Then use this cash to rebalance by purchasing more in the asset category, which has done the worst lately. But even if you have to trigger capital gains, the capital gains tax is at an all-time low and will probably be raised in the future. So go ahead and rebalance your portfolio and generate those capital gains.

If your portfolio had the right asset allocation to begin with, we would currently be advising you to add to U.S. stocks or withdraw from hard asset stocks or fixed income. However, most of the portfolios we see for the first time already have too much U.S. stock and little, if any, hard asset stocks. Again, getting the right asset allocation is always the first step to rebalancing.

Watching the asset allocation balance on a portfolio may not seem like a very active strategy. But because it can increase your returns by over a percentage point a year, it is worth the time and effort. At a minimum, you should have a target asset allocation and an easy way to rebalance it at least once a year.

Photo by Megan Marotta