Data from Vanguard shows that failing to rebalance your portfolio can cost you 0.5% annually, as market gains shift your asset allocation away from its ideal balance.
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This may not sound like much, but the effect compounds over time and can cause some real financial damage, not to mention shifting your portfolio’s risk and reward characteristics.
Where the Hidden Annual Loss Comes From
The first contributor is excess risk. When your portfolio becomes unbalanced, it’s because one of your asset classes has outperformed the others.
If you don’t rebalance, you may end up owning riskier assets than you want. Imagine, for example, that your stocks are up by 40% one year while your bonds fall in value. Nothing goes straight up forever, and when a stock market correction inevitably hits, your portfolio may drop by more than it should according to your intended allocation.
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The second source is lower risk-adjusted returns. Properly allocated portfolios are designed so that different assets balance one another out. As explained by Vanguard, this can contribute to a rise in volatility without the expected higher returns. That’s the very definition of an inefficient portfolio. If the assets in your account don’t balance one another out, you’re courting extra risk while earning lower returns, the opposite of what any investor wants.
The final source is “missing the bounce.” Markets move in cycles. If part of your portfolio underperforms, rebalancing prepares you for when those assets recover. If you fail to rebalance, you’ll remain underweighted, missing the bounce when it comes.
The Math Behind the Loss
Here’s how the math breaks down if you leave your portfolio unbalanced.
Imagine that you have a $500,000 portfolio that earns 7% annually. After 20 years, the value will grow to about $1.93 million. But if your returns are closer to 6.5% instead, you’ll end up with just $1.76 million. You can run these numbers on any online calculator, including the SEC’s Investment Calculator.
If your portfolio drag reaches 1%, the numbers get even worse. In that scenario, you’d end up with just over $1.6 million. That leaves you with roughly $330,000 less than you could have if you simply rebalanced annually.
Rebalancing isn’t an effort to beat the markets. It’s simply a way to keep your portfolio in line with your long-term investment objectives and risk tolerance. Without it, you could be giving up gains that should rightfully remain in your account.
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This article originally appeared on GOBankingRates.com: Here’s the Hidden Annual Loss of Failing To Rebalance Your Portfolio
