Rebalancing vs Not Rebalancing: The Financial Showdown

Imagine you've spent years building a carefully balanced investment portfolio. It's a mix of stocks, bonds, and other assets designed to match your risk tolerance and long-term financial goals. But then, a few years pass, and suddenly, that delicate balance you once had? Gone. Your stocks have grown faster than your bonds, and now you're exposed to more risk than you originally intended. This is where rebalancing comes in. But here's the twist—what if you didn’t rebalance? Could you actually end up better off by letting your portfolio ride the waves of the market? This question has puzzled investors for decades, and the answer is far from straightforward.

The Case for Rebalancing

Rebalancing is the process of adjusting your portfolio to bring it back in line with your original asset allocation. The idea is simple: sell the assets that have grown beyond your target percentages and buy those that have lagged behind. But why would you want to sell your winners and buy more of your losers?

Risk Management: The most compelling argument for rebalancing is risk control. Over time, as certain assets (like stocks) outperform others (like bonds), your portfolio naturally shifts toward a more aggressive stance. Rebalancing ensures you’re not inadvertently taking on more risk than you’re comfortable with. By keeping your portfolio aligned with your original risk profile, you’re less likely to panic during market downturns.

Psychological Benefits: Rebalancing forces you to buy low and sell high—something most investors find difficult to do in practice. It removes emotions from the equation and instills discipline in your investment strategy. Imagine the satisfaction of selling off a portion of a stock that’s soared and using that profit to buy an undervalued asset. It’s a classic move that goes against human instinct but often pays off in the long run.

Consistent Portfolio Performance: Rebalancing can smooth out your portfolio’s performance over time. By locking in gains from top-performing assets and reinvesting them in underperformers, you’re maintaining a steady trajectory toward your financial goals, regardless of market volatility.

However, the process of rebalancing isn’t without its downsides. For one, it often incurs costs in the form of transaction fees and taxes. And then there’s the question: Does it always lead to better returns?

The Case for Not Rebalancing

At first glance, the idea of not rebalancing sounds reckless. But there’s a method to this madness. Some investors advocate for a "hands-off" approach, allowing their portfolio to grow without interference. Here’s why:

Higher Returns: If you leave your portfolio alone, your winners can keep winning. Rebalancing forces you to sell your top-performing assets, but what if those assets continue to rise? By not rebalancing, you might allow your best investments to grow unchecked, potentially leading to higher returns. In a booming stock market, not rebalancing might outperform a strategy that involves regularly selling off gains.

Lower Costs: Rebalancing involves transaction fees, taxes, and time. These can add up, especially for investors with large portfolios or those who rebalance frequently. By sticking with a hands-off approach, you avoid these costs entirely. Over the long term, this could make a significant difference in your overall returns.

Letting Winners Run: Some proponents of not rebalancing argue that the market tends to reward successful companies. If a stock is performing well, it might be because the underlying company is thriving. By allowing your portfolio to drift with the market, you’re essentially betting on the continued success of your winners, rather than capping their growth prematurely.

The Risks of Not Rebalancing

While not rebalancing can sometimes lead to higher returns, it’s important to understand the risks involved.

Increased Risk Exposure: As your top-performing assets grow, so does your risk. A portfolio that started as 60% stocks and 40% bonds could, after several years of a bull market, become 80% stocks and 20% bonds. This is great when stocks are rising, but if the market crashes, you’ll suffer much larger losses than you originally planned for.

Market Timing Risks: By not rebalancing, you’re essentially trying to time the market—a notoriously difficult and often losing game. You’re assuming that your winners will continue to win, but markets are unpredictable. What goes up can come down just as fast.

Psychological Stress: When you don’t rebalance, you’re exposing yourself to greater market fluctuations. This can lead to panic during downturns, prompting you to make emotional decisions like selling at the worst possible time. In contrast, rebalancing enforces a disciplined approach that can help you stay the course during turbulent times.

A Middle Ground: Tactical Rebalancing

Given the pros and cons of both approaches, many investors opt for a middle ground known as tactical rebalancing. Rather than rebalancing on a strict schedule (like annually or quarterly), tactical rebalancing involves adjusting your portfolio only when certain thresholds are met. For example, you might decide to rebalance only if your asset allocation drifts more than 5% from its target.

Flexibility: Tactical rebalancing allows for flexibility in your investment strategy. You’re not forced to rebalance during every market fluctuation, but you’re also not letting your portfolio drift too far from your desired risk level.

Cost Efficiency: By rebalancing only when necessary, you can minimize transaction fees and taxes. This can be especially beneficial for investors who are wary of the costs associated with frequent rebalancing.

Data Analysis: How Do Different Strategies Perform?

To illustrate the differences between rebalancing and not rebalancing, let’s look at some hypothetical scenarios.

Strategy	Average Annual Return	Worst Yearly Loss	Best Yearly Gain	Volatility
Rebalanced Portfolio	6.5%	-15%	20%	Moderate
Non-Rebalanced Portfolio	7.2%	-25%	30%	High
Tactical Rebalancing	6.9%	-18%	25%	Moderate

As the table shows, a non-rebalanced portfolio may offer higher returns, but it also comes with greater volatility and larger potential losses. Tactical rebalancing provides a middle ground, offering solid returns with more controlled risk.

Conclusion: Should You Rebalance?

There’s no one-size-fits-all answer to the rebalancing dilemma. The right approach depends on your financial goals, risk tolerance, and investment horizon. If you value risk control and disciplined investing, rebalancing is probably the way to go. It offers peace of mind and helps keep your portfolio in line with your long-term objectives.

On the other hand, if you’re comfortable with higher risk and want to maximize returns, a hands-off approach might suit you better. Just be prepared for the emotional roller coaster that comes with market volatility.

Ultimately, many investors find that a combination of both strategies—tactical rebalancing—provides the best of both worlds. By adjusting your portfolio only when necessary, you can enjoy the benefits of rebalancing while minimizing its downsides.

So, should you rebalance or not? The answer lies not in the market, but in your own financial goals and the level of risk you're willing to tolerate.