In our last post we talked about portfolio rebalancing and how it relates to the overall asset allocation of an investor’s portfolio. We also walked through an example with a simple two asset class portfolio (stocks and bonds) to show how rebalancing works.
Today we are going to discuss the whys of rebalancing in much more detail. We’re also going to cover a few of the key factors that we need to consider as part of a sound rebalancing strategy.
Why do we Rebalance?
As we discussed in the last post, smart investors select a target asset allocation (and write it down in an investment policy statement) before they put any of their hard-earned dollars to work. However, since assets in a diversified portfolio rarely move in lockstep, the investor’s actual asset allocation usually changes over time.
Thus, the easy answer to the question of why we rebalance is simply this:
We rebalance the portfolio because the actual (or current) asset allocation is different than the target asset allocation.
Technically for disciplined, long-term investors that is true. Unfortunately, it doesn’t answer the question very well.
The reality is that we rebalance for three primary reasons:
1. Risk management
The single most important reason why an investor should rebalance their portfolio is to proactively manage the risk of their investments. Because stocks tend to increase in value over time, if a portfolio is left to its own devices, it will almost certainly become more risky. This is particularly true if dividends are automatically reinvested.
For example, in our previous post, we looked at a portfolio with a target asset allocation of 60% stocks and 40% bonds. After a banner year for stocks, the asset allocation had changed to 66% stocks and 34% bonds.
The new portfolio is certainly riskier than the target and is likely to exhibit higher levels of volatility going forward. In addition, portfolios with a greater allocation to stocks are subject to bigger drawdowns in a bear market. Such declines can test the mettle of many investors.
Thus, it is important to monitor your portfolio and rebalance it when necessary to bring it back in line with the target. For do-it-yourself investors, rebalancing your portfolio once or twice per year is probably sufficient. Just pick a day and mark it on your calendar (e.g. June 30th of every year).
At Wealth Engineers, portfolios are monitored and rebalanced according to a strategic process with a predefined set of rules, rather than on a calendar basis. We typically review all portfolios on a daily basis (and no less than weekly), which allows us to adjust the portfolio whenever a rebalance is warranted. This can help to further reduce risk and also benefit from #2 and #3 below.
2. Opportunity for higher returns
Although managing risk is the most critical reason to rebalance your portfolio, there is another reason that should not be overlooked: the opportunity to increase the returns in your portfolio.
How do you increase returns by rebalancing? Through a disciplined process of selling high and buying low.
Remember, rebalancing involves selling assets after they have significantly increased in price and/or buying assets after they have significantly decreased in price.
This is the exact opposite of what most investors do.
For example, mutual fund data from Blackrock shows that investors chase recent performance (and flee after downturns) almost like clockwork.
In other words, after an asset class does well, investors pour money into funds in the class (buying high). Likewise, investors are quick to exit after a run of poor performance (selling low). This herd behavior causes most investors to significantly underperform the very assets they invest in.
Instead, smart investors select an asset allocation they can be comfortable with through good markets and bad, and then rebalance it using a disciplined approach.
3. Integration with financial plan
The third reason to rebalance your portfolio is to ensure that it is consistent with your financial plan. Although a risk tolerance assessment can provide guidance as to how much risk you are comfortable taking, it does not provide insight into your ability or need to take risk.
That is where your financial plan comes into play. A good financial plan should help you understand at a minimum: (1) how much you need to save; (2) how long you need to save for; and (3) the rate of return you need to achieve to hit your goals.
As the value of your portfolio changes over time, it can have a significant impact on your financial plan. For example, if your portfolio generates higher returns for several years than your plan outlined, an updated plan might indicate that you are on track to retire earlier than expected. Or you might have the option to increase your spending in retirement.
With regards to rebalancing, at least once a year you should revisit your financial plan to determine whether any changes to your portfolio are warranted. If so, the portfolio should be rebalance according to the new investment policy statement and portfolio objectives.