It’s Time To Get Into The Rebalancing Act

By John P. Reese —

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If it ain’t broke, don’t fix it can be a useful mantra in many walks of life, but investors should be wary when applying this idea to asset allocations.

Movements in the market can shift allocations and result in concentrations that might not necessarily fit your risk profile and/or investment goals. Suppose, for example, you create a portfolio comprised of 60% stocks and 40% bonds. If stocks see a period of large returns and the allocation shifts to, say, a 70% stock allocation, you might consider leaving things alone in the hopes that the trend will continue—therefore not fixing what ain’t broke. But this would represent a shift from your original plan and a move not necessarily in the best interest of your portfolio’s overall health. In this example, an investor would have to sell 10% of its equity holdings to return to the original asset allocation. Since the investor would be taking profits from the source of the shift, he would therefore be selling high what he bought low—a cornerstone of wise investing.

If, on the other hand, an optimistic investor puts rebalancing on hold, this will tip the scale toward a higher stock exposure and increase portfolio risk should a market correction, or bear market, occur. Unless your risk appetite or goals change, therefore, asset allocations should be maintained by periodic rebalancing to avoid increased risk to your portfolio.

An American Association of Individual Investors article from 2014 discusses the advantages of rebalancing. The author, Charles Rotblut, CFA, tracked (using data from Vanguard) how three different investor behaviors would impact a moderate allocation portfolio (defined as one with 70% in stocks and 30% in bonds) since 1988. The scenarios illustrated were; (1) a portfolio that was rebalanced each time its allocations were off by 5% or more from its targets; (2) a non-rebalanced portfolio; (3) a portfolio where an investor panicked and got out of stocks each time the Standard & Poor’s 500 Index fell by at least 20%.

The table below shows that the highest absolute return came from letting allocations shift as the market rose. Rebalancing came in second, the article says, but well ahead of the results of the third scenario in which an investor panic sells in the face of a 20% drop in the S&P 500:

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There are a few observations worth noting here.

First is that those who panicked and sold after declines would have been the worst off out of all three scenarios. As Rotblut explains, “By acting to limit short-term loss during a bear market, the investor [who sold at every 20% decline] ended up forfeiting nearly $400,000 in wealth. It’s a massive amount of money to lose by being too focused on the immediate downside volatility caused by broad market movements.”

The second point is that the investor who did nothing and didn’t rebalance the portfolio was the one who ended up ahead by a small amount, but in so doing incurred more risk than the investor who maintained a disciplined rebalancing approach. This is supported by the fact that the No-Rebalance portfolio saw a higher standard deviation (14.2% vs. 12.6% for the rebalanced portfolio) and a significantly higher maximum annual loss (32.8% vs. 26.9%).

Colleen Jaconetti, a senior analyst with Vanguard’s Investment Strategy Group, drove home the point nicely in this article in CNBC.com article from 2015. She says, “People don’t want to rebalance when the stock market is doing well. But what if the stock market did drop 20 percent and they had not rebalanced?” The risk, she says, is that by letting the equity portion stay as-is, investors can end up with a higher proportion of equities than they are comfortable with. If a correction occurs, those same investors may turn skittish and, says Jaconetti, “abandon their strategy altogether.”

New York Times article from last month says that “many investors are suffering from portfolio drift,” adding that, even if an investor’s long-term strategy has been carefully established, “the colossal gains in the stock market could mean that you hold far more stock than you ever intended. In that case, you have taken on unintended risk because your portfolio has drifted far from its original moorings.” The article shows how a 60/40 split of stocks and bonds as of Dec. 31, 2008 would now be 74 percent in stocks and 26 percent in bonds given the massive increase in equity values from the bear market lows nearly a decade ago.

Given the stock market’s 8 year run and current valuation levels it would behoove investors who haven’t been rebalancing to take the opportunity to assess their target asset allocation and to make adjustments with a long term perspective in mind.

Photo: Copyright: hatza/ 123RF Stock Photo

John Reese is founder and CEO of Validea.com and Validea Capital Management, LLC. Validea is a quantitative investment research firm and Validea Capital, a separate company from Validea.com, which maintains this blog, is a asset management firm offering private account management, ETFs and a robo advisor, Validea Legends and Validea Legends Income. John is a graduate of MIT and Harvard Business school, holder of two US patents and author of the book, “The Guru Investor: How to Beat the Market Using History’s Best Investment Strategies”.