Rebalancing is the systematic process of reallocating assets within a portfolio. The objective is to keep each asset's share of the portfolio in line with predetermined percentages. For example, if a portfolio utilizes five different mutual funds and the goal is for each fund to represent 20% of the total portfolio value, the portfolio will need to be rebalanced periodically to maintain the equal weighting. This is because each fund will not likely have the same return each year. To rebalance, an investor sells shares of the best-performing funds and then uses the proceeds to purchase shares of the worst-performing funds.

That's all fine and dandy. At this point, it's practically orthodoxy. But does rebalancing protect a portfolio during periods of market stress? Yes, and I'll show you how. First, a portfolio with steady rebalancing performs better. Second, it ensures that an adequate amount of liquid assets are available in leaner times. Specifically, the bond and cash asset allocation buckets are much fuller in a rebalanced portfolio, should the investor need them in times of market turbulence.

The Longer Term

The rebalancing analyis we used in this study assumes a seven-asset portfolio over a 38-plus-year period beginning Jan. 1, 1970, and ending Oct. 31, 2008. Portfolio assets included in this analysis are large-cap U.S. equities, small-cap U.S. equities, non-U.S. equities, U.S. intermediate-term bonds, cash, real estate and commodities.

Here are the indexes used in the study as proxies for each asset class:

• Large-cap U.S. equities: Standard and Poor's 500.
• Small-cap U.S. equities: Ibbotson Small Companies Index from 1970 to 1978 and Russell 2000 Index from 1979 to 2008.
• Non-U.S. equities: Morgan Stanley Capital International EAFE (Europe, Australasia, Far East) Index.
• U.S. intermediate-term bonds: Ibbotson Intermediate Term Bond Index from 1970 to 1976 and Lehman Brothers (now Barclay's Capital) Intermediate Term Bond index from 1977 to 2008.
• Cash: Three-month government Treasury bills.
• Real estate: Dow Jones Wilshire REIT Index from 1978-2008 and the NAREIT Index (annual returns from 1970 to 1977). 1970 and 1971 were regression-based estimates, since the NAREIT Index (National Association of Real Estate Investment Trusts) did not provide annual returns until 1972).
• Commodities: Goldman Sachs Commodities Index (GSCI). As of Feb. 6, 2007, the GSCI is now known as the S&P GSCI Commodity Index.

To study the impact of rebalancing, we invested a total of $10,000 in the seven-asset portfolio on Jan. 1, 1970. Each asset received 1/7th of the total investment, or $1,428.

We also studied a portfolio that did not use year-end rebalancing. Each of the seven assets received a $1,428 initial investment (for a total portfolio investment of $10,000) at the start of 1970. No additional investments were made into any of the assets, nor were any of the seven assets rebalanced during the 38-plus-year period.

"In the End," above right, displays the results of both portfolios. Over the nearly 38-plus-year period from Jan. 1, 1970, to Oct. 31, 2008, the ending account value of the annually rebalanced portfolio was more than $104,000 larger than the ending account balance in the buy-and-hold client portfolio.

Perhaps even more significant is the massive difference between the ending account balances in bonds and cash. The annually rebalanced portfolio had a final account balance of over $90,000 in bonds, whereas the buy-and-hold portfolio had an ending balance of just under $29,000 in bonds.

The final balances in cash told an even more dramatic story. As the chart above indicates, an initial investment of $1,428 grew to nearly $88,000 in the rebalanced portfolio, but to just under $15,000 in the buy-and-hold portfolio.

Over longer time periods, assets that generate lower returns, such as bonds and cash, will be unable to produce account balances that keep pace with higher-returning equity-based assets. Why does this matter? In today's turbulent environment, it raises three important words-unexpected liquidity needs. Within any multi-asset portfolio, maintaining several assets that will provide immediate liquidity is vitally important. The equity carnage during the fourth quarter of last year is ample evidence of this crucial truth.

The Shorter Term

Does a rebalancing "premium" manifest itself over shorter time periods? Since not everyone holds a portfolio for nearly 40 years, is there a rebalancing benefit over a shorter time-frame, say 20-year periods?

As seen in "Rolling Along" above, the average total portfolio balance over twenty 20-year rolling periods was over $3,000 higher in the annually rebalanced portfolio. The ending bond and cash balances in the rebalanced portfolios were significantly higher than in the buy-and-hold portfolio. One obvious impact of rebalancing is that each asset has a similar ending account balance, which is not true with a buy-and-hold approach.