Think of your portfolio like a garden: To keep it producing the desired results, it needs disciplined care, weeding, and nourishing. Your investment portfolio also requires regular maintenance to control the most important determinant of risk and returns: the portfolio's asset allocation. You maintain control through rebalancing and tax management.
Rebalancing a portfolio means minimizing or eliminating its "style drift," caused by market movement. Style drift causes the risk and expected return of the portfolio to change.
There are some myths about rebalancing, the first being that rebalancing is a "reversion to the mean" strategy. This is false: Consider a portfolio with an asset allocation of 50 percent stocks/ 50 percent bonds. Stocks have returned 10 percent and are expected to return 10 percent while bonds have returned 6 percent and are expected to return 6 percent. The first year, stocks return 9 percent and bonds 7 percent. A strategy based on reversion to the mean of returns would sell bonds (since they produced above-average returns) to buy stocks (since they produced below-average returns). However, since the portfolio would then have an asset allocation of greater than 50 percent for stocks, rebalancing would require stocks be sold to buy more bonds, or buying sufficient bonds to increase the bond allocation to 50 percent.
The second myth about rebalancing is that it increases returns. That will not be the ...