Get Ready for Stocks to Fall: Analyst's Toolkit

Here's why it's important to set up an asset-allocation strategy and stick to it.
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BOSTON (TheStreet) -- Most investors realize that diversification can help mitigate risk and improve returns, but many fail to monitor this critical part of managing their portfolios.

Allowing assets to grow without adjusting them may look fine on paper, but the underlying effects of this passive strategy can cause big problems. Because riskier assets grow faster than conservative investments, such as bonds, failing to rebalance could cause volatile holdings to consume too much of your portfolio.

If the dominant asset class drops, your investments will suffer more than they would have if they had been spread among a wider variety of assets.

To illustrate the effects of rebalancing, let's look at a simple portfolio comprised of a stock index ETF, like the

iShares S&P 500 Index

(IVV) - Get Report

, and a

bond

fund, like the

iShares Barclays Aggregate Bond Fund

(AGG) - Get Report

. Both of these funds provide a good proxy for their respective markets because they encompass many of the holdings investors would hold in their individual portfolios and they are easy to buy.

The general fund characteristics suggest that the S&P 500 Index would have an expected return of about 10% annually, with a standard deviation of about 20%, while the Aggregate Bond Fund would have an expected return of about 5%, with a standard deviation of about 4.3%. Empirical studies have shown the stock and bond markets act independently, so the correlation between the two will be zero. Now we will see the difference rebalancing can make.

As the graph shows, failing to rebalance causes more of the portfolio to be consumed by the riskier asset. Let's say the owner of this portfolio puts $2,500 into it every quarter, putting 60% in the S&P 500 Index ETF and 40% in the Aggregate Bond ETF. Those contributions help keep a lid on the amount of the allocation that shifts towards stocks.

This portfolio starts with a 60% allocation to the stock fund and a 40% allocation to the bond fund, giving it a standard deviation of about 12%. By the end of the time period, the allocation has shifted to 84% in the stock fund with just 16% in the bond fund and the standard deviation jumps to 17%.

As investors age, they have less time to rebuild their savings after the market declines, like it did in 2008. If they don't rebalance, they will increase their allocation to risky assets when the portfolio should be becoming more conservative.

If this portfolio entered 2008 with an increased allocation to the stock fund, the portfolio would have lost 30%. If the owner had shifted the assets back to the planned allocation, he would have lost 19%, outperforming the buy-and-hold portfolio by about 11%. That's no small feat.

The total value of the portfolio will ramp up faster if it's not rebalanced, but the added risk should make most investors think twice about the added gain. The benefits can be washed away in a market with increased volatility. In 2008, the S&P 500 ETF dropped 37% while the Aggregate Bond ETF gained 8%.

A better tactic would have been to rebalance the portfolio to the optimal asset allocation at either a set point in time or when the investments get out of a specified target range.

In the chart below, we rebalanced at year-end for simplicity's sake.

Rebalancing helps the portfolio maintain a constant allocation, with some minor ripples as the investments grow at different rates during the year. By keeping the asset mix consistent, the portfolio's expected return should also remain consistent and, more importantly, the portfolio's standard deviation will remain consistent. While the buy-and-hold portfolio saw its standard deviation ramp up as the weighting toward the stock ETF increased. Rebalancing will eliminate shifts to one asset class or another, keeping its standard deviation at a low 12%.

If these two portfolios started 2008 with $1 million, the buy-and-hold portfolio would have dipped to $704,705 and the rebalanced portfolio would have fallen to $810,480. After the gains of 2009, many may expect the portfolio with the heavier stock weighting to rebound and overtake the rebalanced portfolio, but that is not the case. The rebalanced portfolio would have ended 2009 at $948,585, while the buy-and-hold portfolio would be worth $849,218.

In a market as volatile as the one we have experienced in recent years, it's best to stick to an asset allocation that is tightly governed by your ability and willingness to take risks.

-- Reported by David MacDougall in Boston.

Prior to joining TheStreet Ratings, David MacDougall was an analyst at Cambridge Associates, an investment consulting firm, where he worked with private equity and venture capital funds. He graduated cum laude from Northeastern University with a bachelor's degree in finance and is a Level III CFA candidate.