Earn More Income Without More Risk

“There’s no such thing as a free lunch” applies to the world of investing. To increase your investment returns, you need to accept more risk. There is, however, an important exception to this rule. Increasing your portfolio's diversification does not impact its expected returns but it does reduce its risk and price volatility. By automatically rebalancing your portfolio, you can maximize the benefit of diversification.

The concept of diversification is well known. Diversification involves dividing an investment portfolio across different asset classes in varying proportions to reflect an investor’s goals, risk tolerance and time horizon. Ideally, the performance of the asset classes will be independent of each other. Assume Mr. Investor would like to diversify his $100,000 nest egg by investing in two asset classes: stocks and bonds. Based on articles he's read, he decides to invest 70% of his portfolio in stocks and 30% in bonds. By diversifying in this way, Mr. Investor will enjoy the same investment return as if he did not diversify--but with less gut-wrenching volatility.

Unfortunately, the benefits of diversification tend to decrease with time as the proportions of each asset class within the portfolio change from their desired values. In the example above, assume stocks have a bad year but bonds thrive. When Mr. Investor reviews his portfolio one year later, it contains only $50,000 in stocks but a healthy $50,000 in bonds. At this point, the diversification of his portfolio is very different from what Mr. Investor originally wanted.

The obvious way for Mr. Investor to deal with this problem is to rebalance his portfolio by selling $20,000 in bonds and using the proceeds to buy stocks. By doing so, Mr. Investor’s portfolio will return to his desired proportions of 70% stocks and 30% bonds. There are at least three problems with this solution. The first is procrastination. Mr. Investor may not take the actions needed to rebalance his portfolio because he’s not aware of the imbalance, or he’s too busy. The second problem is human nature. Like most people, Mr. Investor will be hesitant to sell his winning investments (his bonds) or buy more of his losing investments (his stocks) because he’s received pleasure from his bonds and pain from his stocks. Third, he may not want to deal with the tax and paperwork implications of buying and selling his investments. These implications may be trivial in this example, but they may be formidable in real life.

A great way for Mr. Investor to handle the problems associated with rebalancing his portfolio is to set up automatic rebalancing with his broker or financial provider. For example, he could instruct his broker to automatically rebalance his portfolio to his desired proportions once per year. By setting up automatic rebalancing, Mr. Investor will not need to take any other action, and it won’t matter if he procrastinates. The automatic feature will also remove Mr. Investor’s emotions from the equation, and he will be more likely to “sell high, buy low” by selling some of his winners and buying more of his losers. As for the tax and paperwork implications of automatic rebalancing, he can at least take comfort in knowing this is no problem if the investments are held in a retirement account such as an IRA, 401(k) or 403(b) plan.

Some people criticize the concept of automatically rebalancing an investment portfolio because it might be used to replace thinking. This argument makes little sense because there is no reason why an investor cannot periodically review the desired proportions in his portfolio and then make appropriate adjustments. For example, as he ages, Mr. Investor may decide to decrease the percentage of stocks in his portfolio to 60% while increasing the percentage of bonds to 40%. He could then simply change the instructions that he gives to his broker.

Setting up automatic rebalancing is particularly useful for retirement investments since there are no tax consequences to buying or selling. Further, the percentage of plans which allow automatic rebalancing is rapidly increasing. While a 2007 survey by Hewitt & Associates found 42% of large employers offered this option, this percentage is no doubt higher today.

As mentioned previously, one problem with using automatic rebalancing with a non-retirement account is that the associated buying and selling may create headaches when preparing your tax returns. However, this problem can be minimized by setting the interval for the automatic rebalancing at a relatively long time period, such as one year. Another way to minimize this problem is to use automatic rebalancing on only a small number of assets. If you are automatically rebalancing only 3 or 4 assets, the number of buy/sell transactions will be small. Numerous articles are available on the Internet which discuss inexpensive ways to create a diversified portfolio using only 2 or 3 or 4 exchange traded funds (ETFs) or index funds.

For a real-world example of using automatic rebalancing to increase returns without increasing risk, I automatically rebalance my 401(k) plan with an old employer. My assets are diversified among 6 assets classes: 20% in a large-cap index fund; 15% in a medium-cap index fund; 15% in a small-cap index fund; 20% in an international fund; 15% in an aggregate bond fund; and 15% in a Treasury Inflation-Protected (TIPS) bond fund. I have instructed my provider to rebalance my account to these percentages quarterly. Two weeks before the rebalancing is scheduled, I receive a mailed reminder and have the option to cancel or change it (though I have yet to do so). By using this automatic feature, I know it will occur without any action on my part. I also don’t need to deal with the anguish of deciding if it’s a good time to rebalance, or if I should change percentages based on recent events, so it’s not an emotional decision. Finally, since it involves my 401(k) plan, there are no tax consequences or extra work at tax time.