Interesting example of asset allocation and rebalancing in this article, “What the Heck is Asset Allocation.”
He illustrates two cases (over 2 years):
- Case 1: Investing $100,000 in 4 different mutual funds (large-cap, mid-cap, small-cap, and bonds), 25% each. Sell the worst performer after the first year and buy the best performer. Hold for one more year. This leaves you with $96,535 after the 2 year period.
- Case 2: Same as above, but rebalancing the funds after year 1, so that each fund was again 25% of the portfolio. This case leaves you with $103,170.
He also could have shown the case where you just buy & hold for the 2 years:
- Case 3: Using the returns provided in the article, the final value for each fund would be [tex]FV=PV \times (1+i_1)(1+i_2)[/tex] for each fund, where [tex]i_1[/tex] is the return of a fund in year 1 and [tex]i_2[/tex] is the return of a fund in year 2. You would end up with $102,660
It just happens to work out this way because of the data he used. Had he rigged his data so that the Bond fund continued to do poorly in year 2 and the small cap continued to outperform the others, then our results would be different. But in my opinion if you looked at past market data you would find that case 2 above is invariably the best thing to do.