Why We Rebalance

Two nights ago I was visiting with my best friend and his family. His wife asked me how the market has been doing this year. I don't think my response was appreciated. However, it did initiate an animated conversation regarding rebalancing.

It's always fun to tell investors that rebalancing is selling investments that have done well and redeploying the proceeds into investments that have done poorly. In the long run, the theory holds a lot of merit. However, I should probably explain it in less frightening verbiage.

Investors benefit when they're familiar with a few key concepts. Rebalancing is one of them. When you rebalance, you're returning to the expected risk & return characterics in your Asset Allocation.

In short, rebalancing shifts us back to where we belong. Hence, the "balancing" in rebalancing...

Let's say you're a 60% stock / 40% bond investor. Over time it's natural your stocks will outperform your bonds, driving up stock's relative weight in the portfolio. For example, if you let your portfolio ride for a number of years you might end up with 75% stocks and 25% bonds. This allocation might be too aggressive for your goals and time horizon, not to mention your comfort zone.

To further this phenomenon, Vanguard's paper Best Practices For Portfolio Rebalancing shows that if an investor started with a 60/40 portfolio in 1926 and never rebalanced, they'd end up with 99% in stocks by 2009.

It's hard to rebalance. No one likes the short term effect of selling winners to load up on losers. However, when the market is declining the net result is buying investments with higher expected returns at a discount to recent pricing. It's like buying clothes at Kohl's when they're having a sale. Wait. Bad example. Everything is constantly on sale there...

Another real challenge to rebalancing occurs when markets appreciate. In this scenario, an investor is tapping the growth brakes when they really just want to let the good times roll. In a rising market, the investor who rebalances accepts a lower expected return.

I believe investors should rebalance when portfolio conditions dictate, not according to a predetermined schedule, i.e., monthly, quarterly, annually. No investor should ever execute trades just because. This can trigger avoidable trading costs and unwanted tax consequences like short term capital gains that are currently taxed as high as 39.6%.

By leveraging technology to alert me when portfolios drift beyond acceptable thresholds, a good portion of those frequent rebalancing negative effects are mitigated. If you're a DIY investor, Vanguard may still offer a rebalancing program similar to my approach. However, I'm not sure about any of the other discount online brokerages (if you want something other than Vanguard funds).

If you're not familiar with the rebalancing strategy your financial advisor adheres to it's a good time to ask. If it's an automatically scheduled frequency, ask them to do it only when it's warranted. Hint: there is no acceptable answer other than "you got it". Auto rebalancing might actually do more harm than good. Shoot me an email in the footer below if you have additional questions about this.

Sometimes investors need an iron stomach when rebalancing, especially right now. But, the benefit of maintaining a carefully chosen asset allocation is one of the best weapons (not to mention regular contact with your advisor) against making ill-timed investment decisions based on emotion.

Stay balanced, friends!

#assetallocation #investorbehavior