When the market goes up and you see gains in your portfolio, it’s easy to not want to change anything. However, avoiding rebalancing could lead to significant asset drift—the gradual shift in asset allocation as some asset classes outperform others. This can significantly affect your risk tolerance over the long term and make you more vulnerable during a market downturn.
What Is Rebalancing?
There is a difference between rebalancing your portfolio and simply reallocating your assets. Reallocation means shifting money from one asset class to another. This could mean increasing your exposure to intermediate-term bonds by moving cash out of Small Cap stocks, for example.
Rebalancing involves selling assets that have performed well while buying assets that have performed more poorly in order to get back to your original target allocation. For the individual investor, that is often easier said than done, as this typically involves acting counter to the prevailing market sentiment.
For instance, let’s say you want to have an equal balance of stocks and bonds in your portfolio. If stocks significantly outperform bonds over a given period, you would no longer have a 50-50 balance between stocks and bonds. Instead, you’d have a greater portion of your assets in stocks than you may realize. By rebalancing, you would sell some of your stocks and buy more bonds until you get back to a 50-50 allocation in your portfolio.
Benefits of Rebalancing Your Portfolio
At first glance, it may seem counter-productive to engage in a rebalancing strategy. After all, why would you want to sell an asset that has been performing well while purchasing assets that have weighed down your portfolio?
There are two key benefits rebalancing can provide your portfolio: First, as mentioned earlier, your asset allocation changes based on gains and losses in the market. Most likely, since stocks tend to outperform bonds over the long term, you’ll become overweighted in stocks the longer you go without rebalancing. This could lead to a much riskier portfolio than you want.
Rebalancing will also help you implement a value strategy into your portfolio management. Value investing involves purchasing assets that appear to be undervalued while selling assets that appear to be overvalued. Regular rebalancing means you are regularly selling assets that have appreciated (becoming overvalued) in order to use that money to buy assets that haven’t performed as well (becoming undervalued).
For example, imagine retiring in 2007 just before the equity markets sold off sharply in 2008–09. Without a commitment to rebalancing and/or a trusted advisor providing guidance, investors were at risk of not only abandoning stocks altogether, but also of holding too little in equities. Had they deviated from their long-term target allocation in equities, they would have missed out on one of the strongest market rallies of our lifetime from March 2009 to early 2016, as the market rose over 220% during this period.
Rebalance Regularly—Even During Market Turbulence
The obvious question is, how do we combat the urge to alter our original plan in times of turbulence? The answer is that you don’t make decisions at that juncture! You follow your predetermined course of action, which was developed well before arriving at the point where decisions need to be made. The father of value investing, Benjamin Graham, once said, “Investment is most intelligent when it is most businesslike.” In other words, contain your emotions and rely on facts when making judgments. This is exactly the mindset needed when an investor rebalances their portfolio during times of market turbulence.
It should be noted that most professional investors view rebalancing as a way to enhance returns, but perhaps even more importantly, it is a great tool to manage risk. Selling riskier assets—stocks, commodities, private equity—when they’ve performed well to buy more stable assets—bonds, cash—or vice versa, resets the risk/return profile of your portfolio back to the original target. Once you design and implement a portfolio to match your long-term investment goals and risk tolerance, you should preserve its structural integrity. And the best way to preserve your ideal asset allocation is to rebalance regularly—even when markets are volatile.
Regularly Review Your Portfolio to Keep on Track
Keep in mind that just because you have a diversified portfolio and regularly rebalance doesn’t necessarily mean you will achieve better returns than an investor with a portfolio that is heavily weighted in a single sector. However, it will allow you to better manage the levels of risk in your portfolio, which is often a major concern for those in or near retirement.
Maintaining ideal levels of risk and the correct asset allocation is a critical component of any long-term financial plan. Though it's generally not necessary to review your retirement portfolio too frequently (e.g., every day or even every week), it is a good idea to monitor it at least once per year and as major events occur in your life. Taking the time to rebalance your portfolio on a regular basis can help achieve both these goals. Meeting with an advisor to perform regular maintenance now may help you avoid major headaches during the next market correction.
The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual.
Rebalancing a portfolio may cause investors to incur tax liabilities and/or transaction costs and does not assure a profit or protect against a loss.
CFP®, MBA, Series 7 Securities Registration,1 Series 66 Advisory Registration, † Life & Health Insurance License As a CERTIFIED FINANCIAL PLANNER™ professional, Jim brings an extensive retirement income planning background to the team. He regularly writes a personal finance column for The Des Moines Register’s Business...Read More