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Portfolio Rebalancing in This Financial Market Environment

As a refresher, your "target asset allocation" is simply the mix between cash, bonds, stocks, commodities, and possibly other asset classes, that is appropriate for your personal risk tolerance, need for income, and investment time horizon.  Without a target asset allocation, you are essentially sailing the financial markets without a rudder.

Asset allocation is critical because it is by far the most important determinant of the expected return and expected volatility of your portfolio.  Generally, the more a portfolio is weighted towards stocks and commodities, the more we should expect it to return, but the more volatile we should also expect it to be. Likewise, the more a portfolio is weighted towards cash and bonds, the less we should expect it to return, but the more stable we should expect it to be. 

As different asset classes, and different investments within those asset classes, generate disparate returns through time, you will find that your portfolio asset allocation will stray from its target.  "Portfolio rebalancing" is the process of correcting this, of bringing your investment portfolio back into alignment with your target asset allocation.

Why is portfolio rebalancing important?

     1. Rebalancing lends discipline to the investment process.

     2. Rebalancing reduces overall portfolio volatility.

     3. Rebalancing in effect forces you to buy low and sell high.

     4. Rebalancing counters much of the self-destructive behavior that many investors exhibit, i.e. overconfidence, availability bias, and belief perseverance.

Can the benefits of portfolio rebalancing be quantified?

There have been many academic studies on portfolio rebalancing, and these have included a variety of rebalancing techniques and "triggers".  Even the simplest of these, rebalancing mechanically every 6 or 12 months, points to the possibility of increasing annual returns by half a percentage point, while simultaneously reducing portfolio risk.  This is a rare win-win outcome in the world of portfolio management, in which trade-offs between risk and return are the norm.

Portfolio Rebalancing Applied

It's clear that when and how to rebalance is more art than science.  My own philosophy is to try to sell into recent strength a long-outperforming investment within the overweight asset class, and to replace it with a holding in the underweight asset class that I perceive as cheap, or that has exhibited recent weakness.  But then I like to have my cake and eat it, too (or rather I like for my clients to have their cakes and eat them, too.) This approach also appeals to my contrarian sensibilities.

A few years ago, I was interviewed by reporter Ian Salisbury for his Wall St. Journal MarketWatch article entitled, "Rethinking the 'Rebalancing' Rule Book".  In the article, I am quoted as saying, “I’m overweight equity, because if I sell, where do I go?”, referring to the quandary presented back then by being underweight cash and bonds, asset classes whose yields at the time just about guaranteed that they would lose money versus inflation.  In other words, rebalancing in that financial market environment (selling stocks to buy bonds or cash) was more like having your cake, but having to eat it with a dirty fork, to continue the analogy above.

Fast forward five or six years, and investors are still likely to be overweight U.S. stocks versus other asset classes, if not more so.  What has changed is that asset classes other than U.S. stocks have become relatively more attractive from a risk-return perspective than they were at the outset of 2013 when that article was written.  Back then, 10-year Treasuries yielded less than 2%; today 2-year Treasuries offer 2 3/4%, with cash equivalents liked savings and money market accounts not far behind.  International developed and emerging markets stocks have also become relatively more attractive than domestic stocks by many measures.  And commodities remain a very interesting addition to a traditional stock-bond portfolio, and especially with signs of inflation re-emerging.

Bull markets have a way of reinforcing bad investing habits.  Investors get lazy, undisciplined and over-confident without consequence.  And this bull market, characterized by low volatility and very brief, shallow corrections has been particularly insidious in this respect.  Those that have foregone portfolio rebalancing have been rewarded for it so far despite longer-term evidence to the contrary.  The old Nike ads are now perfectly applicable to portfolio rebalancing - "Just Do It".

About the Author

Paul Winter, MBA, CFA, CFP® is a Fee-Only financial advisor and fiduciary in Salt Lake City, UT. His independent wealth management firm, Five Seasons Financial Planning, provides professional portfolio management and objective financial planning services to individuals and families, and to their related entities including trusts, estates, charitable organizations, and small businesses.  

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