With expected returns compressed by low interest rates and above-average stock market valuations, financial advisors are challenged in helping their clients achieve their retirement goals. Even before management costs, the numbers seem daunting.

Take an asset mix of 50% investment-grade bonds and 50% stocks with expected annual returns of 3% and 7%, respectively, over the next decade. On first impression, some simple math tells us this portfolio has an expected return of 5%.

Yet, this arithmetic overlooks a vital source of incremental return: a “return premium” can be earned by periodically rebalancing the portfolio to the target mix of 50% bonds and 50% stocks.

The act of selling the asset that has appreciated on a relative basis and buying the lagging asset adds return by “selling high” and “buying low” while maintaining the risk parameters of the portfolio.

For example, from January 1926 to February 2014, large-cap stocks had an annualized return of 10.1% and intermediate-term government bonds returned 5.3%. Using these numbers, a 50/50 mix is calculated to have returned 7.7%.

However, the actual historical return of this portfolio, if rebalanced annually, was 8.2%; the premium of 0.5% per annum reflects the return to diversification maintained by rebalancing.

Moreover, the premium gained from rebalancing can be boosted by adding assets that exhibit the right blend of volatility and correlation. Using the prior example, by shifting into a portfolio mix of 20% small-cap stocks and 30% large-cap stocks with the 50% bonds, the annualized historical portfolio return would have increased to 9% from 8.2%. Of the 0.8% increase in return, only half is from the higher returns of small-cap stocks. The other half of the incremental increase is from the jump in the rebalancing premium to 0.9% from 0.5%.

A global equities portfolio also creates a rebalancing premium.

Rebalancing is a contrarian action – you trim the winning asset to buy the loser. And therein lies the challenge. Human nature being what it is, investors tend to chase – not sell – the winners. You can find it an overwhelming task not only to reach but persuade each one of several hundred clients to sell some of the winning asset classes to buy the losers.

Many advisors are restructuring their practices to manage their clients’ portfolios more effectively. Some are becoming portfolio managers; others are outsourcing the management of their clients’ portfolios to discretionary portfolio managers. Rebalancing then is executed in a disciplined fashion without client approval. Other advisors are using new, low-cost funds that feature predefined asset mixes and automatic rebalancing.

You simply cannot let your clients’ portfolios drift. Rebalancing combines risk management and proper compliance with the sensible pursuit of higher returns. You can’t ignore this combination.

Michael Nairne is president of Tacita Capital Inc. of Toronto, a private family office and investment-counselling firm. The company, its principals, employees and clients may own the securities mentioned herein.

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