STRIKING THE PERFECT BALANCE: THE ART OF PORTFOLIO REBALANCING

Life is like riding a bicycle. To keep your balance, you must keep moving. -Albert Einstein

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According to Wikipedia: Rebalancing refers to the process of returning the values of a portfolio’s asset allocations to the levels defined by an investment plan. Those levels are intended to match an investor’s tolerance for risk and desire for reward.

Portfolio rebalancing is defined as changing to remain the same (having portfolio balance.) It’s been said that one needs balance in life. The same principle holds with portfolio management. Without proper balance (facilitated by rebalancing) asset classes that have grown, and asset classes that have shrunk, move away from the original target allocation and must be realigned, or rebalanced.

In the definition provided by Wikipedia, it should be noted that asset allocation levels are defined by an investment plan. 

So, the first step is not throwing together a bunch of asset classes that you like, or feel strongly about, and trading those asset classes periodically. 

The formulation of an Investment Plan is the first step. A written investment plan creates a well-defined and well-thought-out guide that is implemented, followed, and modified over time.

If you have not read or listened to the posts and podcasts titled HAVING A “PLAN” and BUILDING A PORTFOLIO, now would be a great time to catch up. In HAVING A “PLAN” the importance and wisdom of having a well-thought-out plan was discussed. BUILDING A PORTFOLIO provided the basic building blocks of portfolio construction.

The main blocks of portfolio building are portfolio goals, asset classes, portfolio type, time horizon, portfolio use, risk tolerance, asset allocation, portfolio diversification, and asset class ratio. All of these subjects were discussed in BUILDING A PORTFOLIO and will not be revisited here in detail.

A well-defined portfolio is normally implemented over an extended period and contains an appropriate, risk-adjusted, and diversified group of assets that follow the design formulated in the Investment Plan.

Why Rebalance?

Things change over time. Portfolio assets go up and down in value based on time horizon, asset class, political climates, world events, and multiple and varied reasons. The asset ratio established in the Investment Plan changes because risk tolerance decreases over time, assets have increased or decreased in value, plan goals change, or the distribution phase of retirement has begun. There are multiple reasons why portfolio balances change over time, and those changes will skew the original asset ratio.

The current portfolio won’t reflect the original plan design and may increase risk instead of having risk decrease over time. A diversified portfolio should mediate risk. When an asset or asset group rises the portfolio becomes unbalanced and large dollar amounts in certain assets increase the risk of greater loss if those particular assets decline in value. 

Emotion or Mechanics?

 Emotions can override any level of intelligence. -Morgan Housel                       

What makes rebalancing difficult is that emotions get in the way of mechanics. It is very difficult emotionally to take an asset that has risen in value and sell part of that asset to purchase assets that have lost value. You sell a winner to buy a loser, and that doesn’t make sense emotionally. But, the Callan periodic table (described in: BEST LONG-TERM INVESTMENT -FACT OR OPINION?) indicates that what is a winner this year will probably not be a top-performing asset in the next few years. Assets rotate away from a top performer periodically, and may eventually end up at the bottom of performance rankings. The common stock market adage is to sell high and buy low. That is exactly what you are doing when you rebalance.

On a personal level, a REIT Index fund that I owned had several years of stellar performance. Each year with rebalancing a part of the REIT fund would be sold and poor-performing funds in my portfolio would be bought. It was very hard to sell a fund that was making 25-30% a year to buy funds that were making little or no money. It was only after the REIT index had a year where it lost about 30% and other funds were up in value that I truly realized the wisdom of rebalancing. With rebalancing, I had avoided a big loss with the majority of REIT profits because the profit had been sold to buy other funds “on sale.”

The stock market is the only market where things go on sale and all the customers run out of the store…. -Cullen Roche

The Mechanics of Rebalancing

In simplest terms, rebalancing a portfolio incorporates selling the funds or assets that have increased in value to buy funds or assets that have lagged in performance. Whether the portfolio consists of two or two hundred assets, the process is the same.

Let’s look at a simple example:

An investor has a three-fund portfolio with (60%) S&P 500 Index, (30%) Total Bond Index, and (10%) REIT Index fund. The value of the portfolio is $100,000.00.

In the table above the Funds and Assets in the portfolio are listed in the first column. The Target Percentage is listed in the second column. These are the asset ratios identified and decided upon in the Retirement Investment Plan. The Current Value of each asset is listed in the third column. In the fourth column, the Target Values are based on the total portfolio value ($100K) divided by the percentages listed for each fund (60% of 100K= 60K, 30% of $100K= $30K, 10% of $100K= $10K.) The last column is the Action needed to rebalance the portfolio back to the target percentages. ($10K) S&P 500 must be sold to bring the $70K balance back to the target of $60K. ($5K) of the REIT Index fund must be sold to bring the $15K balance back to the target of $10K. ($15K) must be added to the Total Bond Index fund to bring the $15K balance up to the target of $30K. The proceeds of the S&P 500 sale ($10K) and the proceeds of the REIT sale ($5K) are used to buy $15K of the Total Bond Index fund. (Note that the total amount sold [$30K] equals the total amount bought [$30K].) The portfolio value is still $100K, but now the target percentages and target values are re-established and the portfolio is rebalanced. This process is repeated periodically depending on the strategy used for rebalancing (see below.)

The greater the number of funds in a portfolio, the more involved the rebalancing procedure becomes.

When is it Best to Rebalance?

There are two main strategies for rebalancing:

• Calendar-based– there is no true consensus on the best time frame to rebalance. Long-term investors normally rebalance once a year. Investors with different outlooks and goals may rebalance quarterly, or even monthly. If rebalancing is done annually, then the portfolio is realigned or rebalanced at the same time each year. If rebalancing is done semi-annually, or quarterly, then the portfolio is rebalanced on the same date every three or six months.
• Constant mix– focuses on maintaining a certain percentage composition of an asset in a portfolio. This is known as a constant-mix strategy with bands or corridors. Each asset is maintained at a certain percentage of the total portfolio and will be rebalanced when the asset moves outside of a set percentage (either up or down.) For example a portfolio may have a corridor or band set at 5%. This means that if an asset moves up or down more than 5% in value, the portfolio is rebalanced to bring the asset back within the corridor.
• Some investors use a combination of Calendar-based and Constant mix strategies and rebalance on both target dates and whenever the portfolio crosses a trigger band or corridor.

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Advantages and Disadvantages of Rebalancing

Investopedia outlines the pros and cons of rebalancing:

Advantages

• Rebalancing can keep investors’ portfolios aligned with their risk tolerance and need for a certain amount of return.
• It maintains a pre-determined asset allocation set by an investment plan.
• It’s a disciplined, unemotional investment approach that can reduce exposure to risk.
• It can be changed as investors’ financial needs and investment goals change.
• Rebalancing can be done by experienced individual investors or handled by portfolio managers.

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Disadvantages

• Rebalancing involves transaction costs, which may reduce net income.
• Selling securities that have increased in value to rebalance a portfolio might lead to investors missing out on an upward price trend of those securities.
• Investing knowledge and experience is required to rebalance as needed and reduce exposure to risk appropriately.
• Unnecessary rebalancing can increase costs for an investor.

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Does Rebalancing Really Matter, Help, or Increase Long-Term Returns?

According to Michael Kitces:

The conventional view of portfolio rebalancing is that it is a strategy to enhance long-term returns by periodically selling the investments that are up (and overweighted) to buy those that are down (and underweighted), in the process of realigning the portfolio to its original target allocation.

Yet the reality is that because most investments go up far more often than they go down, systematic rebalancing is actually more likely to just consistently liquidate the best-performing investments to buy ones with lower returns instead – especially when rebalancing across investments that have very significant return differences in the first place (e.g., rebalancing from stocks into bonds).

As a result, rebalancing may be helpful as a risk management strategy – otherwise higher-returning stocks would compound to the point that they are significantly overweighted relative to lower-returning bonds – but it’s only when rebalancing amongst investments with similar returns in the first place that rebalancing provides a return-enhancement potential.

Ultimately, the fact that rebalancing may actually reduce long-term returns isn’t a reason to avoid it (even if returns are lower, risk-adjusted returns may be improved if the risk is reduced by even more), and sometimes returns really can be enhanced (when rebalancing across similar-return investments, such as amongst sub-categories of equities). Nonetheless, it’s crucial to recognize the role that rebalancing really does – and does not – play in a long-term portfolio!

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Final Thoughts

• Even if your portfolio is professionally rebalanced, it’s important to understand the principles, basics, and mechanics for rebalancing.
• Rebalancing returns the values of a portfolio’s asset allocations to the levels defined by an investment plan.
• Portfolio assets go up and down in value based on time horizon, asset class, political climates, world events, and for multiple and varied reasons. 
• If rebalancing is done regularly, with defined parameters, the tendency to let emotion play a part in the decision is reduced.
• Rebalancing is a disciplined, unemotional investment approach that can reduce risk exposure.
• Rebalancing involves transaction costs, which may reduce net income in after-tax accounts that are rebalanced.
• Rebalancing may be helpful as a risk management strategy – otherwise, higher-returning stocks would compound to the point that they are significantly overweighted relative to lower-returning bonds – but it’s only when rebalancing amongst investments with similar returns in the first place that rebalancing provides a return-enhancement potential.

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