Rebalancing: Restoring Balance to our Portfolios

We are all familiar with the many techniques for restoring balance in our lives for better health and performance.  Interestingly, our investment portfolios are also at risk for becoming imbalanced and can be restored through a discipline called rebalancing.

It is a common practice for investment managers to periodically rebalance client portfolios to get them back “on track” and studies show that individual investors are less likely to do so.

First, how does an investment portfolio become imbalanced?  It is the very nature of markets to move up and down, and in so doing, the allocation of our assets will drift from our original target.  For instance, if our targeted asset allocation is a balanced portfolio of 60% stocks and 40% bonds, a stock market rally can easily shift us to 70% stocks and 30% bonds. Conversely, a bond market rally combined with a flat stock market may shift our allocation to 50% stocks and 50% bonds.  Given our target, the first allocation (70/30) exposes us to more risk than we intend, and the second allocation (50/50) exposes us to less risk than we intend.

While rebalancing a portfolio is a simple concept, its execution requires discipline.  Timing, frequency, trading costs and capital gains consequences must be considered.  Investment managers and personal investors must be willing to behave counter-intuitively, meaning they must sell winners and buy underperformers to get back in balance, a form of disciplined “buying low and selling high.” 

Rebalancing on a regular schedule (i.e. quarterly, semi-annually or annually) takes emotion out of the process so that the portfolio guides you, not the market.   The negative to this strategy is that you might spend time, incur trading costs, and generate taxes for little benefit if your allocation is not far out of balance.  Another strategy is to rebalance only when the major asset classes (stocks, bond and alternative securities) deviate from a pre-defined percentage range.  You might determine you can tolerate a five percentage point deviation over and under your 60% equity target.  If stock allocation rises to 66% and above, or declines to 54% and under, you are prompted to rebalance – either buying or selling depending on the direction. 

Precision in execution is not necessary.  Rebalancing rules can be flexible and ideally accommodate an investor’s unique circumstances.  A strategy simply requires frequency of monitoring, a determination of how large the variance can be by asset class, and a decision as to whether the portfolio is rebalanced to a target or a range.

Russell Investments1 compares a buy-and-hold portfolio vs. a once-a-year rebalanced portfolio (within a 10% tolerance range) for the period 1988 to 2014.  The buy and hold underperformed the annual rebalanced portfolio at 9.0% vs. 9.4% on an annualized basis.  More significantly, the standard deviation, or volatility measure of the buy-and-hold portfolio, was 10.5% compared to 8.9% for the annual rebalanced portfolio.  While results will vary depending on the time period studied, they serve to show the power of a disciplined rebalancing strategy. 

Your investment portfolio will be rewarded with periodic rebalancing.  History shows that the longer term investor can expect more positive results with a smoother, less volatile ride over time.

1Russell Investments “The Importance of a Rebalancing Policy”, November 2014