A crucial part to a successful investment portfolio requires that you occasionally rebalance your portfolio. Due to the volatility of the market, the asset allocation you select might change from time to time. If you select 80% stocks and 20% bonds as your AA, swings in the market can cause these numbers to veer off in different directions. Re-balancing your portfolio allows you to maintain your risk tolerance by selling or buying certain asset classes.
Essentially, rebalancing forces you to sell some of your outperforming funds and buy more of the underperforming asset classes. Smart investors know that the markets are cyclical and many investors get burned when they continue adding more and more money to well performing asset classes. Generally, broad asset classes tend to revert to their average. What this means is that if stocks go way up, eventually they’ll settle back down somewhere in the middle. Rebalancing allows you to sell these hot investments before they turn cold.
Rebalancing won’t always boost your returns though, in fact sometimes it does the opposite. We know that stocks tend to outperform bonds so the natural tendency of a portfolio will become more and more weighted towards stocks. Selling stocks when they’re high will actually tend to lower our returns over time but it should allow you to effectively manage the risk that comes with your portfolio. Most people invest in a larger percentage of stocks because they expect them to have a higher return. Obviously a 100% stocks portfolio will give you the highest returns, but can you handle the associated ups and downs?
Why We Rebalance
Rebalancing a portfolio essentially ‘resets’ it to it’s original state. My reason for re-balancing is simple: I don’t want to invest based on any type of emotion. Once I’ve selected my AA, I don’t want to go and start adding more money to bonds during a bull market because I think they’ll outperform stocks. This is speculative behavior that can lead to disaster. There are thousands of active funds and fund managers that try to chase returns by actively buying and selling to outperform the market. A handful of them may be successful over a 5-10 year period. But almost none will be able to outperform the market over extended periods of time. What makes me or any other novice investor think they can do it better?
Most investors who follow their emotion will simply add money to whatever asset class is the hottest. If stocks are doing well, they put money there. If bonds are performing well, they’ll put money there. A systematic rebalancing strategy allows you to keep your desired AA and maintain your risk tolerance. The contributions to my 401k and Roth IRA are the exact same as my AA. Since my investment strategy is 90% stocks/10% bonds, every time I contribute money to my retirement accounts, I use these percentages.
Re-Balancing is About Managing Risk
There’s actually been some evidence put forward by authors like Rick Ferri that shows a non re-balanced portfolio will perform very similar to a rebalanced portfolio. But they key distinction is the rebalanced portfolio is still less risky. That is to say, it will have fewer down years and the declines(and inclines) won’t be as great. For the average investor, this is a good thing. Managing risk is one of the toughest parts about investing in my opinion. A lot of people think they can handle 80 or 90% stocks, but when they see a large drop in the market, will they feel the same way?
Asset allocation and your rate of contribution(for younger investors) will play a larger role than rebalancing in the performance of your portfolio. But it’s important to know how you can effectively reduce the risk by taking advantage of the cyclical nature of the markets. In my next article, I’ll discuss when is a good time to rebalance. I like to keep it simple so re-balancing as little as possible is the best strategy for me. I’ll show how often you need to rebalance and what can trigger a rebalance.
Readers, have you rebalanced your portfolio lately? Do you use automatic contributions to your retirement accounts or do you invest using another strategy?
-Harry @ PF Pro