Portfolio Rebalancing 101
Before we talk about why portfolio rebalancing can be bad, it is important to understand the rebalancing concept. It is also good to understand why most investment managers are in favor of the strategy. Rebalancing is the process of selling some assets and buying others to align your portfolio with a stated goal and target asset allocation. As an example, a manager may specify the percentage of all assets that should be held in stocks and what should be held as bonds. The goals for a portfolio’s performance have a basis in the investor. Some investors are looking to grow their funds and would choose investments with higher risk potential. Other investors may look for income generation and will have holdings that offer regular interest and dividend income. Investments can, and do, change in value. Markets and economies change, and individual businesses change. Holdings may increase or decrease in market value or have changes in the interest or dividend return they offer. A holding that was attractive ten years ago may no longer seem as attractive in the current market. Because of this constant change, many financial advisors suggest regularly rebalancing your portfolio.
Asset Allocation
Asset allocation exists to help avoid risk through diversification and reach specific investment goals. That is an important concept and one you will revisit in a moment. Allocation is about avoiding risk. Investments usually fall into one of three categories: Within each category, the investments can be further classified by investment risk and yield. Bonds are considered low-risk assets but generally pay a relatively low return compared to stocks. U.S. Treasurys—used a risk-free investment in calculations—is seen as the most secure investment, which is why they usually pay the lowest return. Stocks are considered a higher-risk investment. They can offer the investor a higher return both in the growth of market share value and in dividends. Some stocks—like penny stock and those of start-up companies—are seen as more speculative. Speculative investments have a higher risk profile and usually offer a greater return to the investor.
Risk Tolerance
Just as no two snowflakes are the same, no two investors are the same. Each investor brings individual needs, goals, and time horizons to the portfolio allocation table. Younger investors who are still in their prime earning years can go further out on the risk horizon. More senior investors may wish to play their cards a bit closer to their chest and seek less risky investments. So, based on these factors, you likely want a specific percentage of your portfolio in stocks and a specific percentage in bonds to help you reach your optimal gains while limiting risk. For example, a younger investor might have a target allocation that is 80% stocks and 20% bonds, while an investor retiring might want 60% stocks and 40% bonds. There is no right or wrong allocation, just what makes sense for the specific investor’s scenario. However, over time, asset allocations tend to drift away from the target. It makes sense, as different asset classes provide different returns. If your stock holdings grow by 10% over a year while your bonds return 4%, you will end up with a higher portfolio value in stocks and a value in bonds than your original allocation. It is when most people would tell you to rebalance. They say you should sell some stocks and buy some bonds to come back into your target allocation. But there’s a downside hiding in plain sight. When you do this, you’re selling an asset that is performing well to buy more of an underperforming asset. This possibility is the core of the case against portfolio rebalancing.
The Fine Line–Risk Management and Profit
The purpose of a target allocation is risk management, but that leads to owning more of something that makes you less money. Consider this example with all returns remaining static. Let’s say you have a $10,000 portfolio that is $8000 (80%) stocks and $2000 (20%) bonds. Over the year, your stocks return 10%, and bonds return 4%. At the end of the year, you have $8,800 in stock and $2,080 in bonds. The total value of your portfolio is now $10,880. You now have 81% of your portfolio value in stocks ($8800/$10880 = 81%) and 19% in bonds ($2080/$10880 = 19%). Rebalancing says you should sell some of that $800 profit from your stocks and use that to buy more bonds. However, if you do that, you will have more bonds that pay you 4%, and less invested in those stocks that paid you 10%. If the same thing happens next year, selling stocks to buy more bonds leads to a lower total return. While in this example, the difference might be a difference of less than $100 over a year, your investment time horizon is far longer than one year. In most cases, it is decades. If you were to lose out on just $25 per year over 30 years at 6% interest, that is about $2,000 in losses. Bigger dollars and interest rates make the disparity even more harmful to your portfolio. Also, our example did not consider the cost of broker commissions to buy or sell holdings. It also did not consider the tax burden on the earned income that will be realized once it is sold.
Historical Performance
This effect isn’t limited to stocks versus bonds. Over the last five years, the S&P 500 has far outperformed emerging markets, with a 92.88% five-year return on the S&P 500 compared to just 12.07% from a popular emerging markets index. If you were to have sold the S&P to buy more emerging markets, it would have cost you big time over the last five years. Of course, asset allocation is rooted in the idea that maximizing returns isn’t the only objective of an investing strategy: You also want to manage risk, especially if you’re getting closer to retirement and wouldn’t have time to recover from a significant loss in the market. As such, rebalancing is more important as you get older and more worth the downside of selling off a well-performing asset. Consider motif investing as well.
