Rebalancing May Be More Important Than You Think

in Education-RSS, Personal Finance Essentials by

Most investors have some notion that they should be rebalancing their investment portfolio, but few have a strategic approach to doing so. This is unfortunate. Increasing evidence suggests that rebalancing is important to long term success.

First, what is rebalancing? It is the act of incrementally selling things that went up and buying things that went down (or went up less) in order to move portfolio weights back to their intended levels. There are many rebalancing strategies.

Having studied them intensely, I have my own opinions about how rebalancing should be managed, but 80% of the battle is won by doing some periodic rebalancing and remaining disciplined about it. Most people, if given the opportunity to try to time rebalancing, will get it wrong by following herd mentality and selling at the wrong time. Also, it doesn’t need to be done that often. We use sophisticated software to check daily if some type of rebalance makes sense. For those without it, every year or two is enough.

Rebalancing should be done at the asset allocation level as well as at the individual security level. Traditionally, the main goal of rebalancing was to control risk and keep portfolios aligned with investor goals. However, it is now commonly accepted that rebalancing increases risk-adjusted returns, and may even increase absolute returns.

Capital markets tend to be volatile and cyclical. No single investment or style can outperform indefinitely. By rebalancing back to a target weight, overall return will be increased when styles shift. This is tough for many people because trends can last a long time, and selling winners can create adverse tax impact.

The following chart demonstrates how rebalancing can improve return. It is a ten year growth of a one million dollar portfolio with a 50% 7-10 Year Treasury bond allocation and a 50% S&P 500 Stock Index allocation. The red line is rebalanced back to the target annually.

The rebalanced portfolio grew by over $100,000 more. This is significant. Because rebalancing is most powerful in choppy markets, the results will not always be as dramatic.

And yes, there will be periods when rebalancing mutes return when trends are running. Also, if you believe stocks will outperform in the long run, it is technically best never to rebalance them down. But for those also concerned with risk and who judge performance over full market cycles, a strategic rebalancing plan makes sense. Please note that before you can have a strategic rebalancing plan, you must first have a strategic asset allocation, which I hope you do.

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Craig Birk, CFP®

Craig Birk, CFP®

Craig Birk is a member of the Personal Capital Advisors Investment Committee. He also serves as Vice President of Portfolio Management. Prior to Personal Capital Advisors, he was an integral leader within the portfolio management team at Fisher Investments. During Craig’s time there, the company increased assets under management from $1.5 billion under management to over $40 billion. His responsibilities included risk management, portfolio implementation oversight, and management of all securities and capital markets research analysts. Mr. Birk graduated from the University of California at San Diego and has earned the Certified Financial Planner® designation.
Craig Birk, CFP®

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