The Long Run: Pick Up the Pieces of Your Asset Allocation Puzzle

Portfolio Pitfall #3: Failing to Rebalance

A 1988 study of TIAA-CREF participants found the median number of asset allocation changes and rebalancing by an individual over his or her investing lifetime was zero -- never! More recent studies have yielded similar results. This is incredibly silly, but it is true.

Over every 20-year period, stocks return an annual average of about 7.2% -- but in the short term, markets are incredibly volatile, which can totally disrupt an investor's asset allocation. For instance: Let's say your asset allocation in 1994 was 60% stocks, 30% bonds and 10% cash. If you didn't rebalance, by the end of 1999 your asset allocation would have been 78% stocks, 17% bonds and 5% cash.

To show the benefits of a little diversification and rebalancing, I asked the good folks at Vanguard Group's statistics department to determine how a 50%-50% portfolio -- the 50% stocks represented by the (VFINX Quote)Vanguard 500 fund, the 50% bonds by the (PTTAX Quote)Pimco Total Return fund -- would have performed over the past seven and 10-year periods, provided investors rebalanced back to 50%-50% at the end of each quarter.

I chose 50%-50% for simplicity's sake, and also because that's what Benjamin Graham advised investors in 1972 to do -- I'm guessing he wouldn't advise 50% large-cap stocks and 50% bonds in 2003. (Side note: Reading The Intelligent Investor is probably one of the two or three most important things an individual can do to ensure a successful investing lifetime -- if everyone who bought Dow 36,000 in 1999 purchased this book instead, it would've saved a lot of heartbreak.)

Here are the results for the 50-50 portfolio, compared with an all-stock portfolio and an all-bond portfolio.

The 50-50 Exercise A regularly rebalanced portfolio offers a better risk-return option for investors with less volatility*
Portfolio	Average Annual Return for Seven Years (1996-2002)	Average Annual Return for 10 Years (1993-2002)	Best Month	Worst Month
50-50 Portfolio	8%	9.23%	10.84%	(-6.89%)
100 Stock (Vanguard 500)	6.82	9.27	21.39	(-17.22)
100 Bonds (Pimco Total Return)	7.94	8.3	6.5	(2.69)
Source: Vanguard. *Returns are after expenses, but don't factor in Pimco's front-end load.