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Opportunistic Portfolio Rebalancing (Part 1)

Readers of this blog know that selecting an appropriate asset allocation is critical to ensuring an investor has success in the markets. At the most basic level this is because if an investor chooses a risky allocation such as 80% stock, and can't stomach the volatility when the markets inevitably fall, they will sell at a most inopportune time.  At Mallard, we arrive at client asset allocations after evaluating their tolerance for fluctuations (i.e, risk tolerance), their financial capacity to handle fluctuations, and their overall need (or lack thereof) for taking on risk in the first place. Once these variables have been assessed through tools, surveys, and the financial planning process, the asset allocation will be prudently established.

Considering the importance of establishing an appropriate asset allocation, it is then vital to maintain that allocation over time. Because a portfolio’s underlying investment holdings produce different returns over time, the portfolio allocation will drift from its target allocation. Unconsciously allowing this to inadvertently occur results in a portfolio with an entirely new risk-and-return profile than originally selected!  

Portfolio Rebalancing
Portfolio rebalancing maintains the proper asset allocation over time. The basic concept of portfolio rebalancing is to realign the investments in the portfolio to generally stay in line with the originally selected weightings.

For example, let's assume a client has a $1 million portfolio that is split evenly between stocks and bonds. Further, let's also imagine the portfolio has dropped in value to $950,000 (not hard to imagine). More specifically, as shown in the left side of the table below, the portfolio's stock allocation dropped by 20% (from $500,000 to $400,000), while the bond allocation rose by 10% (from $500,000 to $550,000).

Due to this portfolio’s volatility, the client’s current stock allocation is now 42%, while their bond allocation is 58%. Assuming this client purposefully and consciously selected an asset allocation of 50% stocks, should they really be holding a 42% stock allocation after the bear market? It is highly unlikely their risk tolerance, capacity, or need has changed. Worse, imagine a strong stock market rally over the week. Assuming this client did not rebalance, they will not receive the higher returns that are commensurate with a 50% stock portfolio as they only had a 42% stock portfolio at the time the rally took place!

Now, what must occur to bring this portfolio back to its selected asset allocation? As shown in the table, $75,000 of bonds must be sold in order to buy $75,000 worth of stocks. Only then will the desired asset allocation be reestablished through the process of rebalancing. Imagine for a moment how it would feel to take proceeds from the asset class that has done well (bonds) to buy more of the asset class (stocks) that has been going down the tubes! No doubt this would be a hard trigger to pull, especially considering it must be done at a time when it will feel as if stocks will not recover anytime soon. Rebalancing goes against our very nature and is very hard because when you are supposed to be buying stocks, you will likely be reading some very compelling reasons to sell instead.

Benefits of Portfolio Rebalancing
So far we have touched on two of the benefits of rebalancing. First and foremost is the objective of maintaining a desired level of portfolio risk (and therefore expected return). If you need the expected return that a 50% stock portfolio will provide, but now (after the bear market) you only have a 42% stock portfolio, your expected long-term returns will have dropped from about 6.5% to 6.0%. If you do not rebalance, you are now inadvertently changing your portfolio strategy and results.  

The second benefit of rebalancing is instilling discipline in the implementation of your portfolio management. Rebalancing forces us to take money out of precisely those asset classes which have recently been stellar performers, and reinvest it in the asset classes that have of late been deeply out of favor. Rebalancing causes us to act against our own impulse to chase performance. It forces us to systematically sell high in order to buy low. Another way to think about it is that rebalancing compels you to be a contrarian - someone who does the opposite of the crowd.  Financial contrarians tend to be wealthier than those who simply run with the emotional herd. Rebalancing is thus the bridge from simple diversification to highly disciplined opportunism. This is exactly the opposite of what most investors do, which in turn explains why most investors underperform not only the markets but their own investments.

This brings us to the third and most exciting benefit of portfolio rebalancing: the generation of enhanced risk-adjusted returns as a result of the discipline of buying low and selling high. Rebalancing triggers a sale of the investments that are up the most (because they are over their target weighting due to better relative recent returns) and a buy of the investments that are down the most (because they are under their target weighting due to poor relative recent returns). The value of rebalancing make intuitive sense in that we are continuously taking some profit from the winning investments and reallocating those profits to the losing investments.

Rebalancing exploits the short-term volatility of markets and their tendency to overshoot fair value in both directions, but then eventually revert to their mean. There is a lot of volatility among asset classes, and rebalancing puts this volatility to work for you.

In September 2016, Vanguard determined that portfolio rebalancing potentially adds up to 0.35% in returns when comparing two risk adjusted portfolios where one is rebalanced annually versus the other that is not rebalanced (and thus drifts). Similarly the Envestnet Quantitative Research Group also tackled the value of rebalancing in a white paper entitled “Capital Sigma: The Advisor Advantage” and found value of 0.44%. Regardless of the exact value added through rebalancing, we know it should be positive over time. So, we know that rebalancing is good for us, and good for our results.

 Stated most simply, portfolio rebalancing is designed to instill the discipline we all need in order to maintain our desired portfolio risk/return, while at the same time enhancing returns.

In the next post, we will cover the implementation issues associated with rebalancing focusing on the differences between time-based rebalancing (e.g., every year), and tolerance-band rebalancing.

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