Rebalancing Your Portfolio: An Important, Overlooked Task
Other than making sure you’re saving enough for an investment goal, the most important decision an investor can make is deciding what percentage of his/her assets to “allocate” to each asset class. These asset classes typically include cash equivalents, bonds, and stock (and sometimes, just two classes, or a combination of all three).
Generally, in each economic environment, one asset class will outperform the others. For example, in the late 1970s, “cash was king,” handily outperforming both stocks and bonds. From 1995 through 1999, stock market returns dwarfed cash and bonds. And from 2000 through 2002, bonds led the pack. In 2022, both the stock market and bond markets fell sharply in tandem, certainly a rare occurrence. Prognosticators can’t consistently predict which asset class will lead in the future. But for the long-term investor it doesn’t matter. Once you select a suitable “asset allocation” (i.e., one that reflects your goals, time horizon, and risk tolerance), simply make certain that your portfolio doesn’t veer too much from your chosen allocation. That’s where rebalancing comes in.
Let’s say that you have selected a long-term asset allocation of 15% Cash Equivalents, 50% Bonds, and 35% Stock. Let’s also assume that you established this allocation at the beginning of the year and didn’t add to or make withdrawals from the portfolio during the year. See Row 1 in the Table Below.
|
|
Cash Equivalents |
Bonds/Fixed Income Securities |
Stock/Equities |
|
Row 1 |
15% |
50% |
35% |
|
Row 2 |
10% (Year1) End Value |
35% (Year1) End Value |
50% (Yr1) End Value |
|
|
+5% Rebalance |
+15% Rebalance |
-15% Rebalance |
|
Row 3 |
15% |
50% |
35% |
When you review your Asset Allocation at the end of year, you’ll notice that the equity (i.e., stock) portion of your portfolio swelled to 50% of its value, while the bond portion dropped to 35%, and cash equivalents shrank to 10% (See Row 2 of the Table). Here, a “casino mentality” might suggest doing nothing and “letting your winners ride”. However, a prudent investor would take the gains from the “winning asset class” (in this case, stock) and buy the asset classes that did less well (in this case, cash, and bonds) to return to his original allocation (See Row 3). This process is called “rebalancing”.
When you rebalance, you are really selling “your winners” and buying “your losers,” not a very appealing proposition for most people, at least in the short term. However, if you look a little closer, you’ll also recognize that rebalancing “protects you from yourself” by forcing you to “sell high” and “buy low” every year. In our illustration, bonds might outperform equities the following year or both assets might tank simultaneously (as they did in 2022). Those who hadn’t rebalanced would have lost a larger portion of their portfolio in a stock market downturn. Why? Because the stock portion of the portfolio grew to a larger proportion of the whole.
Rebalancing takes discipline and courage. It typically forces you to liquidate investments that have performed well recently and buy investments whose value may have fallen. For example, the stock portion of an investor’s portfolios shrank dramatically during 2008. At the end of 2008, rebalancing would have asked investors to add to their stock market holdings (assuming they had set an appropriate asset allocation in the first place) just at the time when “pundits” were predicting further market losses. However, investors who rebalanced were rewarded handsomely (with the greatest annual stock market surge since World War II in 2009). Rebalancing doesn’t always work that dramatically, but 2009’s market performance is an important reminder of the importance of rebalancing.
Experts differ on how often to rebalance, but most agree that you should do so annually. Some experts also suggest you rebalance if your “asset allocation” drifts more than 10% from its prescribed percentages during the year. For investors, the key is to rebalance at least annually and to have a plan in place to make it happen. For investors with a significant portion of their assets in tax-deferred accounts, rebalancing can occur without triggering any taxable capital gains. Some investors prefer to rebalance by directing their new investment contributions to their “under-performing” asset classes until the portfolio returns to its prescribed allocation. Though an acceptable option, it’s easy to forget to re-direct your new contributions once you’ve completed the rebalancing process. Again, the key is to choose a rebalancing method and stick with it.