Rebalancing, Our Old Friend
Photo by Piret Ilver on Unsplash
Have you heard of “rebalancing” your investments?
What is it? How does it work? Is it actually our old friend?
Let’s take a look.
First, there needs to be “balance”
In order for something to be rebalanced, I suppose it needs to have been balanced first.
Balance, in this context, is about finding and implementing an investment allocation that’s appropriate for you. That is, finding the right balance between your investments.
This is often communicated in percentage terms between stocks and bonds. For example, a “60/40” portfolio (said as “sixty forty”), will have 60% of its assets in stocks and 40% in bonds.
The appropriate balance of investments for you is dependent on, well, you. When working with our clients, we look at two major areas to decide on the best balance for someone: (1) their age (more specifically, where they are in something we call the Financial Life Cycle) and (2) the types of risks they are taking, or are comfortable taking, elsewhere in their lives. We go through a questionnaire with our clients to lead us to appropriate percentages for them, whether it’s 60/40, 50/50, or any other mix. We then change their investments to bring them in line with the agreed-upon percentages.
What causes your investments to become unbalanced?
Usually, it’s caused by one or both of the following:
Market action: That is, the stock and bond markets going up or down over a period of time.
Selling or buying you’ve initiated: Perhaps you’ve been adding to your portfolio (like saving in your 401(k) or a brokerage account) and investing it. Or perhaps you’re withdrawing from your portfolio for living expenses. Doing these things may be causing your overall asset allocation to drift from its target.
While these fluctuations may seem minor in the short term, they can lead to your overall portfolio carrying substantially more or less risk than you initially wanted. A portfolio that becomes overweight in stocks takes on increased volatility by having more exposure to the inherent short-term unpredictability of the stock market. Conversely, a portfolio that drifts towards too much bond exposure may sacrifice growth potential over the long run.
To take a simple example:
Let’s say you have a portfolio of $100.
You start with a 60/40 allocation, or $60 in stocks and $40 in bonds.
Stocks increase by 20% over the course of a year, while bonds stay even.
That means the stocks are worth $72 now and the bonds are still worth $40.
So your 60/40 portfolio is now a 64/36 portfolio, or 64% in stocks and 36% in bonds.
As time passes, you might find that your portfolio has gotten too far away from the initial 60/40 target, causing you to wonder if you should make any changes.
Which leads us to…
…rebalancing
What does it mean to rebalance?
Investment rebalancing is the process of realigning the weightings of the assets in your portfolio. This typically involves periodically buying or selling assets to maintain your desired asset allocation. For instance, if your target allocation is 60/40, but due to market movements your portfolio shifts to 70/30, rebalancing would involve selling some stocks and buying bonds to restore the allocation back to 60/40.
At its core, it's a forcing mechanism to buy low and sell high.
When stocks do well over a period of time and become too large of a percentage of your portfolio, you sell some to bring you back closer to your target allocation (the "sell high" part).
When stocks do poorly over a period of time and become too small of a percentage of your portfolio, you buy more to bring you back closer to your target allocation (the "buy low" part).
This is fairly intuitive. Markets tend to go up and down in cycles, so rebalancing naturally encourages the act of buying low and selling high, without the need to try to fruitlessly “time the market”.
Why is rebalancing important?
Well, I previously referred to rebalancing as our old friend. I didn’t mean that in the getting-along-in-years old kind of friend. But rather rebalancing is like that friend you regularly see and is really good for your happiness and well-being.
Rebalancing:
Promotes engagement: In order to rebalance you first need to check your portfolio to see if it needs to be rebalanced, which is a useful exercise in and of itself.
Maintains risk levels: Over time, different assets grow at different rates. Without rebalancing, a portfolio can become overweight in higher-risk assets, increasing overall portfolio risk. Regular rebalancing ensures that you maintain your desired risk level.
Enforces discipline: Rebalancing helps you stick to your investment strategy, regardless of market fluctuations. As described above, it encourages buying low and selling high, as it often involves selling assets that have performed well and buying those that have underperformed.
Reduces emotional investing: Markets are volatile, and emotional reactions can lead to poor investment decisions. By adhering to a regular rebalancing schedule, you can mitigate the impact of emotional decision-making, ensuring your portfolio remains aligned with your long-term goals.
Optimizes returns: While rebalancing doesn’t guarantee higher returns, it can help optimize your portfolio’s performance by maintaining your target asset allocation. It helps your investments work efficiently to meet your financial objectives.
How often should you rebalance?
There are a few different approaches you can take:
Calendar-based rebalancing: This involves rebalancing your portfolio at regular intervals, such as quarterly, semi-annually, or annually. It’s simple and ensures periodic adjustments.
Threshold-based rebalancing: This approach involves rebalancing whenever the allocation of an asset class deviates from the target allocation by a predetermined percentage, such as 5% or 10%. It allows for more flexibility and responsiveness to market movements.
Hybrid approach: Combining calendar-based and threshold-based methods, the hybrid approach involves periodic reviews with adjustments made only if asset allocations have deviated beyond set thresholds.
At Spencer Financial Planning, we check our clients’ portfolios several times a year, and sometimes more often if markets are volatile or a particular client’s circumstances change. We will normally rebalance when someone’s asset allocation has drifted more than 20% in relative terms from its target. For example, if the target is 60%, we’ll normally rebalance if the percentage reaches 48% or 72%. There are other factors we consider, but that’s the primary approach.
Is it just about stocks and bonds?
Nope.
Rebalancing isn't just about the allocation between stocks and bonds.
We often need to rebalance within our stock or bond exposure.
Perhaps your U.S. vs. non-U.S. stock balance has drifted. Or your growth vs. value stock balance. Or between certain mutual funds. Etc etc.
It’s worthwhile to consider rebalancing within all of these areas.
What does this mean for you now?
At Spencer Financial Planning, we recently hit our rebalancing thresholds for many clients (as of May 2024 … if you’re reading this way in the future, you can ignore this part…).
Why? As you may know, stock markets have done phenomenally well over the past few years. As a result, many of our clients have recently hit their upper thresholds for stock exposure. That has triggered us to rebalance.
Do you need to re-look at your asset allocation?
Perhaps your allocation has moved too far away from where it ought to be.
(Side note: As mentioned above, we've had quite the run-up in stock prices the past few years, but I have no idea if market losses are around the corner. And I have no interest in trying to time the market.)
Final thoughts
Investment rebalancing is a vital part of maintaining a healthy and efficient portfolio. It manages risk, enforces discipline, and optimizes returns, keeping you on track to achieve your financial goals.
If you have questions about rebalancing or need assistance with your investment strategy or financial planning, don’t hesitate to reach out to us by clicking the Start Here button in the top right corner.