In the last 25 years, the stock market has experienced several bull markets – from the 1990s tech boom to the current seven-year rally.

In the midst of such bullish periods, it can be tough to reduce exposure to an asset class that’s on a tear because it usually feels like you’re going to miss out on further growth.

But here’s the good news: Bringing allocations back into balance not only kept risk in line with a portfolio that wasn’t rebalanced, it delivered a higher return, according to research from Capital Group.

The potential risk-return benefits of periodic rebalancing are demonstrated in the chart below. It shows two hypothetical portfolios – represented by stock and bond indexes – each with a target weighting of 60% stocks and 40% bonds.

One portfolio is rebalanced back to the 60-40 target level at each month-end when the equity allocation moves above 66% or below 54% of the total portfolio. The other is never rebalanced.

Somewhat counterintuitively, the rebalanced portfolio experienced slightly more volatility over this time frame as measured by standard deviation. But the value of rebalancing is most evident in the rebalanced portfolio’s average annual return. Over the 25-year period, it averaged an annual gain of 6.8%, while the non-rebalanced portfolio resulted in a 6.3% average annual return.

Rebalancing Can Mean Greater Return With Comparable Risk

This may be surprising given the number of bull markets that have occurred over the past two and a half decades. It might seem that letting a portfolio’s stock allocation become oversized would have meant better results. Yet allocating back to the 60-40 target actually would have achieved a greater return than a portfolio whose allocations were allowed to drift.

So what are some typical rebalancing strategies? Investors should speak with their financial advisor to develop a plan, but there are two basic types of rebalancing:

  1. Periodic rebalancing: Set a calendar reminder to reset your portfolio to its target allocations on a fixed schedule, such as annually, quarterly or monthly. For example, if stocks have had a strong run and now represent 65% of the portfolio, then 5% of its total assets would be sold from the stock allocation on the preselected date.
  1. Threshold rebalancing: The portfolio is adjusted if an asset class moves from its target by more than a certain amount and exceeds your allowable tolerance range – for example, plus or minus 5%. Selling the oversized asset class and buying the undersized asset class adjusts the portfolio back to the target allocation. Alternatively, asset classes can also be adjusted back to the limit of a preset range rather than back to a fixed target allocation.