Balance is important in your portfolio, just like balance between work and play, office and family are important to your life and personal well-being.
Because we use a strategy for our clients based on broad, global diversification, regular rebalancing is especially important. Our portfolios typically contain many different “asset classes” — U.S. large, medium, and small companies, international large, medium and small companies, emerging market holdings (such as China and India), real estate and bonds. There are often more than 6,000 different companies represented in a broadly, globally diversified investment. Diversification spreads your risk, and is just the opposite of “putting all your eggs in one basket.” It tends to give you more consistent performance and good downside protection.
As you might expect, all these different asset classes don’t all go up together — they take turns, and each asset class usually has its day in the sun at different times. In a diversified strategy, rebalancing helps you to take advantage of the individual performance of each asset class.
You probably know that your investment portfolio is being rebalanced on a regular basis, but you might not know why. Is it for higher returns? For maintaining the agreed-upon balance of investments that is in your risk tolerance comfort zone? Does rebalancing help manage portfolio risk?
The answer to the above is “yes,” “yes,” and “yes,” but with a qualification. Rebalancing an investment portfolio is most importantly a form of discipline, a way to reduce the impact of those dangerous emotions of greed and panic in the investment process.
During a bull market, stock prices rise faster than bond values, causing them to make up a larger percentage of the portfolio than you signed on for. Similarly, in a bear market, stocks will fall, while bonds often rise, causing your portfolio to become more conservative. Real estate investments and commodities often rise or fall at different times than stocks or bonds, pulling your overall percentage allocations away from the target mix.
When you rebalance, you’re selling some assets that rose in price and buying the ones that went down. For us, if an asset class rises in value more than 2 to 5% in a 3-month period, depending on the asset class, we will usually sell some if it while it’s up high, locking in some of the gains. Then, we use the proceeds from the sale to buy some of another asset class that looks like a bargain at the time. This discipline results, over time, in consistently buying low and selling high.
THREE WAYS TO REBALANCE
1) The easiest is to use whatever new money is coming into the portfolio, monthly or quarterly, to buy the assets that have gone down, allowing you to make consistent adjustments that keep the portfolio at its recommended allocations.
2) Another possibility is to rebalance at certain times of the year—every three, six or twelve months.
3) Or you could follow a more sophisticated process, and rebalance whenever assets deviate by more than certain set percentages from the baseline asset allocation.
Using a simple mix of 60% stocks and 40% bonds shows that rebalancing using the percentage deviation method tends to lead to higher overall returns from the beginning of 2000 to January 2016.¹ Wider bands sometimes produce higher returns (and fewer rebalances), although of course there is no guarantee that this would be the case in the future.
Perhaps most importantly, rebalancing brings you back, over and over again, to the allocation that you established when you started your investment. If you are working with a Certified Financial Planner™ or CPA, this allocation was designed to give you the long-term returns that would best accomplish your most important goals in your comprehensive financial plan.
When it comes to making decisions in a time of crisis, having a rebalancing policy in place ensures that buys and sells will be made with discipline, rather than emotion.
¹ 5/22/2017 Seeking Alpha