Many financial professionals tout portfolio rebalancing as the key to your financial success. But is it really that important? Or is it just another smoke screen Wall Street uses to convince you they know more than you do? Let’s take a look.
What Is Portfolio Rebalancing?
This financial maneuver is meant to automate your process of buying cheap and selling dear. The best way to explain is by way of example. Let’s say you have $100,000 and you go for an initial 50/50 split between equity and fixed income. As a result you sink $50,000 into each asset class.
After a year the equity portion of your portfolio grows to be worth $60,000 but the bonds drop to $40,000. If you believe in rebalancing you would then sell $10,000 of the equity portion of your portfolio and buy $10,000 more in bonds. This returns you to the 50/50 split you originally had. And it also forces you to sell high and buy low. That’s because you are selling high (the appreciated stocks) and buying cheap (the bonds that fell in value). It doesn’t help you diversify your portfolio but it is meant to reduce your risk.
It’s simple and probably sounds pretty good to you. But is it a smart move? It depends on who you ask.
Some advisors are rebalancing freaks. These people point to attractive investment track records over long periods of time it. But other managers with equally impressive results have entirely different opinions on the matter.
They argue that it just doesn’t make sense to sell assets that are performing well – and that’s exactly what portfolio rebalancing does. It’s like taking the golden egg and hard boiling it. By the same argument, they feel that there is no logic to buying as asset that is declining in value.
That’s like trying to catch a falling knife and it’s equally as dangerous.
In the example above, the rebalancing critics ask you to consider how rebalancing hurts you if equities continue to rise and bonds continue to decline. And if you think about it, they have a good point too.
And it gets more complicated. Other managers *(me included) define portfolio rebalancing differently. They suggest you take the exact opposite path. Buy more of the best performing positions and sell the weaker ones.
Bottom line? Rebalancing has its pros and cons. It can work for you or against you. The best way for you to decide how to rebalance your assets is to first make a decision about investment strategy and stick with it. No investment approach is perfect.
Do you rebalance your portfolio? How? What do you like about it? What do you dislike about it?
Neal Frankle says
Comment from Jeff above:
There are times that will happen–nothing is perfect when it comes to
investing, but I guess a lot of it depends on what the goal is. My clients
aren’t looking for maximum growth as much as prudent profits.
Maybe an illustration will help. An example of event-driven change in
allocation occurred in May/June of this year. Bernanke came out and talked
about the possibility of ‘tapering’ and interest rates and markets reacted
rather violently–stocks down and interest rates surging. There was
incredible volatility in traditionally staid bond-land. If I remember the
number correctly, there was a 10% loss in the 10-year UST YTD through Q2.
Over the last couple of years, I have had a large allocation to
bond-oriented investments because I thought the risk/reward ratio was better
there. And it has worked out very well the last few years. But, in my
opinion, all of that changed in May/June based on the Bernanke. If we are
entering a period of rising interest rates then the risk/reward ratio has
shifted away from bonds and more toward equities.
So as the bond-oriented investments started declining I began incrementally
moving money out of them and into cash (still not changing the overall
target allocation). It became apparent to me that this was more than a
short-term hiccup and it was at that point that I change my allocation
targets.
I use the term ‘target’ because even though money may be targeted to ‘X’,
that doesn’t mean the money is invested right away. The actual positions
will be different from the targets based on the strategies used, the
markets, etc.
Thanks for the question and for the terrific site!
Neal Frankle says
Hey Jeff. This is similar to what I do except I allow the market to signal when an event is “significant”. As you say, nothing is perfect but I believe the approach you and I describe is far better when it comes to delivering prudent profits (I love that term!) and peace of mind… Thanks and I hope to hear more from you sir.
Jeff Voudrie, CFP® Professional says
Great comments. I also approach re-balancing differently by dynamically adjusting strategies and allocations as events dictate. In other words, it seems that event-driven adjustments make more sense to me than calendar-driven ones. @JeffVoudrie
Neal Frankle says
I have found that it’s very difficult to adjust portfolios around events but rather based on the market itself. Have you been plagued by whipsaws?