Is it time to rebalance?

Is it time to rebalance?

To rebalance or not to rebalance; that is the question. Alright, that may be a slight overstatement but with the Dow Jones reaching all-time highs and closing at 21,005.19 on March 3, 2017 (LINK:https://www.bloomberg.com/news/articles/2017-03-03/s-p-500-makes-it-six-weeks-of-gains-as-economic-signals-brighten) if it’s not on your mind perhaps it ought to be. Rebalancing sounds simple in theory but in practice can actually be quite complicated. In this post we will look at the what, why and when of rebalancing your portfolio.

What Is Rebalancing?

Let’s start with the question you may be wondering but don’t want to ask - what is rebalancing?

I’m so glad you asked! At Words on Wealth (LINK: www.wordsonwealth.com) I like to translate the financial jargon for my readers.

Rebalancing is the act of bringing your investment portfolio back to it’s target allocation. Hypothetically speaking, let’s say you have what’s known as a 60/40 portfolio. That would mean you have 60% of your investments invested in stocks and 40% invested in bonds and cash. Now, in real life many of us hold additional assets in our portfolios such as real estate, commodities, or a small business. (Yes, if you own a small business you need to take that into consideration as you create your asset allocation.)

What many people are seeing now as we reach stock market highs is that the stock portion of their portfolio is creeping higher and higher. This is generally speaking a good thing (you’re making more money on paper), until it’s not. Unfortunately, with an un-rebalanced portfolio as your equity holdings increase the risk (standard deviation) of your portfolio is likely increasing as well.

Quick definition of standard deviation in plain English: standard deviation is how wide a range of returns your investment might typically produce. If your hypothetical portfolio has an average projected return of 7% and a standard deviation of 10% then approximately 68% of the time your stock will have a return between -3% and 17%. That range is the average return of 7% plus or minus 10%. Taking that one step further, using standard deviation as a measure we could estimate that 95% of your returns would fall within 2 standard deviations from the mean. In our example that would give you a range of returns from -13% to 27%.
Why Rebalance?
Which brings us back to your portfolio that has hypothetically shifted from a 60/40 portfolio to an 75/25 portfolio. Which means that if the stock market sells off your portfolio may lose a lot more than you were anticipating at your original 60/40 allocation. Why does this matter? Depending on your time horizon, those big losses can do a lot of harm to our chance of meeting our goals. Not just from the pure mathematics of the loss but also from a behavioral standpoint. The pain of the loss may drive you to make a decision that is not in your long-term best interest.
Loss Aversion
It turns out humans don’t just like “winning,” they hate losing. It’s called loss aversion. (If you are looking for a great take on how loss aversion intersects with money please read this brief post from Carl Richards: http://www.nytimes.com/2013/12/09/your-money/overcoming-an-aversion-to-loss.html) We actually feel the pain of loss more intensely than we feel the joy of a gain. This loss aversion can cause investors to sell out of the stock market when stocks are selling off- to stop their losses. This selling low is essentially the opposite of investment maxim to “buy low and sell high.”

As Michael Kitces has suggested,(LINK: https://www.kitces.com/blog/is-rebalancing-supposed-to-enhance-returns-or-reduce-them/) rebalancing is not necessarily about enhancing returns but rather reducing risk. Although, ideally rebalancing also allows an investor to “buy low and sell high” by selling the parts of the portfolio that have performed well and buying the assets in the portfolio that have not. It is important to acknowledge that for rebalancing to increase returns beneficial market timing is required.
When to rebalance?
Great, now you understand why financial planners are always jabbering about “rebalancing.” The next question that arises in many people’s minds is - when should I rebalance? How often should I rebalance?

The good news is, generally you don’t need to rebalance all that often. Some experts suggest you only rebalance every one - two years. (LINK: https://blogs.cfainstitute.org/investor/2015/08/04/to-rebalance-or-not-to-rebalance/) Vanguard has suggested that at a high level (looking at your stock vs. bond allocation) if your portfolio is off by 5% points then it is probably time to rebalance. (LINK: https://investor.vanguard.com/investing/portfolio-management/rebalance) I prefer to look a little deeper and rebalance portfolios at a relative level. When I review a portfolio I look to see how much small cap, large cap, developed international and emerging markets have gained or lost compared to simply looking at your overall stock to bond allocation.  I prefer more frequent reviews of asset allocation because markets move in ways that are not neatly timed with annual or quarterly rebalancing. As Michael Kitces (a prominent writer, researcher and speaker within the financial planning community) lays out in his post “Finding the Optimal Rebalancing Frequency - Time Horizons vs. Tolerance Bands” (LINK: https://www.kitces.com/blog/best-opportunistic-rebalancing-frequency-time-horizons-vs-tolerance-band-thresholds/) a 20% percent relative threshold does a nice job of allowing the market to run a bit before rebalancing. It also recognizes that certain bear markets (such as the 1987 bear market) occur quite quickly. If you wish to take advantage of those events to “buy low” a static time horizon of annual rebalancing could be too long.

This 20% threshold is backed up by a research study conducted by Gobind Daryanani CFP(R), Ph.D. published in the January 2008 edition of the Journal of Financial Planning. In Daryanani’s January 2008 article he asserts that the benefits of this range-based rebalancing outweigh the trading costs that are incurred. It should be noted that he assumed a flat $20 fee for trades. If you pay sales loads on trades within your accounts the benefit may be reduced. You can read the full article here: http://www.tdainstitutional.com/pdf/Opportunistic_Rebalancing_JFP2007_Daryanani.pdf
Practical Implications
It is easiest to implement this type of range bound rebalancing using software (your financial planner may already use such a program) although it is not impossible to do it manually. One benefit of having a system in place is that investors may find it easier to take the emotion out of the decision making process. Let’s face it, when stocks have tanked 20-30% or more it takes a strong stomach to sell your bonds and buy more stocks. Yet this is precisely what rebalancing theory suggests. Although it may be difficult, studies (LINK: http://www.tdainstitutional.com/pdf/Opportunistic_Rebalancing_JFP2007_Daryanani.pdf) show that it’s worth it. Talk to your Fee-Only Financial Planner about how optimal rebalancing can be implemented in your portfolio.
About the Author
Lauren Zangardi Haynes, CFP(R), CIMA is a Fee Only financial planner and blogger in Richmond, VA. She writes on personal finance for families at www.wordsonwealth.com. You can read more about her background here: