Long-term perspective, discipline and patience are the most important ingredients of portfolio success. But emotional, short-term behaviors like panic selling at lows and elated buying at highs can have detrimental long-term consequences, including dramatic portfolio underperformance.

Consider the daily returns of the Dow Jones Industrial Average (DJIA) from 1991 to 2015. A $1,000 investment over that period would grow, assuming dividend reinvestment, to $12,016. But if you were out of the market on the 10 best days, your $1,000 investment would have grown to just $6,141. This illustrates the value of staying in the markets for the long run rather than jumping in and out of the market.

Another important element of a long-term plan involves rebalancing your portfolio periodically to keep it allocated to your desired mix of stocks, bonds and other factors of return such as small and value stocks.

Imagine investing in a simple “60/40” portfolio 30 years ago: 60% invested in the broad U.S. stock market and 40% in short-term corporate and government bonds. Now, let’s examine three different approaches to rebalancing and see how well this portfolio does in each case.

The table below shows the return and risk (as measured by standard deviation of returns) of the stock and bond markets in which we are investing:

Case #1 – No Rebalancing: This approach would have generated an average annual return of 7.8%, but with a fairly high risk of 12.3%. When you don’t rebalance, your portfolio becomes “stock-heavy” because over longer horizons stocks tend to grow more than bonds. Over our hypothetical 30-year period, the allocation to stocks drifted to 85% of the portfolio at their highest point. Of course, at a higher stock percentage, you will be in a different (higher) risk profile, and you’ll be exposed to more volatility.

Case #2 – Monthly Rebalancing: If we assume a 1% transaction cost for rebalancing back to target each month, this portfolio returned 7.7%. However, the risk of this monthly-rebalanced portfolio was cut significantly — from 12.3% down to 10.4%.

Case #3 – Quarterly Threshold Rebalancing: If we rebalance the portfolio back to 60/40 each quarter, taking action only when the mix is outside a pre-determined threshold — say, more than +/-4% — we see our return move up to 7.9% and our risk decline to 10.4%. The advantage of this approach is that transaction costs are cut by an estimated 66%.

Rebalancing in and of itself does not provide enhanced returns. In all three cases above, the long-run return was essentially the same. The real benefit of rebalancing is keeping you in your chosen risk profile. If your portfolio drifts to a higher stock exposure than you intended, a sharp, temporary market drop may cause unexpected losses in your portfolio. Young investors may be able to wait for the temporary market correction to recover, but those closer to or in retirement may not.

Sticking with your plan can help you stay invested in a variety of market environments. Your Advisor can work closely with you to help you stay focused on the long term and help you achieve your goals.

Payel Farasat