Rebalancing, Explained

Editor’s Note: A version of this post appeared today in the San Antonio Express News:

A former student at Trinity sent me a Facebook message recently. He linked to an advertisement message for an investment advisory company that emphasized the importance of ‘rebalancing’ one’s investment portfolio every quarter or every year.

I realized I had not taught that principal at Trinity in our personal finance course last Spring. When the link came in on Facebook with the simple query from my student: “What is rebalancing?” I thought “Uh-oh, I missed that one.”

To make it up to that student, as well as to anyone else who might have the same question, here’s the quick explanation of rebalancing.

Rebalancing is one of those investment things you should do regularly, like brushing your teeth (only less frequently) or going to your college reunion (only more frequently). Once a year rebalancing is fine.
The point of rebalancing is to avoid two big No-Nos of investing:
1. Overexposure to one particular type of risk; and
2. The “Buy-high, Sell-low” investment behavior that everybody unwittingly does.
I’ll illustrate the simplest form of rebalancing with an example, assuming you have just two types of investments in your portfolio: a stock mutual fund and a bond mutual fund.
Let’s say you and your investment advisor agreed that you needed the 60/40 allocation to stocks and bonds that 98.75 percent of all investment advisors inevitably urge on their clients.
[Quick aside: I totally disagree with this allocation, and I’m not an investment advisor, so for both reasons please don’t think I’m recommending this for you. In fact I wouldn’t recommend it for the vast majority of people, but that’s a whole other column – or series of columns to come – in the future.]

Ok, back to my example, which will happen to match up – by pure coincidence! – with how 98.75 percent of your investment advisors have set up your portfolio.]

After one bad year in the stock market in our example here, let’s say stocks have dropped by 12 percent and bonds have returned a positive 5 percent, and now your portfolio allocation has shifted due to the market.
The new portfolio at the end of Year 1 now has a 56 percent stocks to 44 percent bonds allocation.

Here’s where the rebalancing part comes in.
When rebalancing at the end of the year you would sell some of your bonds – in my example 9.6% of your bond allocation so that it only makes up 40 percent of your portfolio again. With the proceeds of the bond sale you would purchase stocks, also returning stocks to just 60 percent of your portfolio. You would now begin Year 2 with your previously agreed-upon 60/40 asset allocation.
Next year, let’s say the stock market rebounds, returning a positive 18 percent, while bonds return just 1 percent overall.
Using numbers from my example, you end up with a 0.66% larger portfolio at the end of Year 2 through rebalancing. That may not seem like much, but those little amounts add up over time. If you have a $100,000 portfolio you would be $660 richer after just one rebalancing.

Let’s extend the example one more year. At the end of Year 2, before rebalancing, you have a 63.6% stocks and 36.4% bond mix. We’ll have to sell about 5.6 percent of our stocks to return to our preferred 60/40 mix.
In Year 3, let’s say stocks return a positive 8 percent and bonds return positive 3 percent. You will now have a portfolio 2.1% higher than if you had never rebalanced, or $2,100 on your original $100,000 portfolio. The math works in your favor this way with any asset allocation in which assets have different returns in different years. It also works just as well with more than two types of assets.

I’d like to list a few more important points about rebalancing, why it works, and also some caveats.

First, the act of regular rebalancing forces you to “Buy-low, Sell-high,” at least on a relative basis. Whichever asset class has outperformed the others will be the one you sell (high) and whichever asset class has underperformed will be the one you buy (low).

Second, while regular rebalancing makes sense, I doubt it makes sense to do this more than once a year. If you have a taxable account (a non-retirement account) then the tax costs of selling winners may outweigh the benefits. Also, frequent trading is always a mistake, so rebalance with moderation.

Third, because of point number two, if it’s possible for you, the best way to rebalance is not through selling existing investments, but rather through new investments. If you regularly contribute to an investment account, you can ‘rebalance’ your portfolio without tax consequences by simply purchasing more of whatever has become underweighted in your portfolio. This has the happy effect of allowing you to buy (relatively) low with your new investments, rather than to do what everybody else does, which is chase whatever hot sector has recently outperformed.
This may seem super-duper obvious and it is indeed super-duper easy to do.

But!
Most people don’t do it. After Year 1 of losing 12 percent in the stock market, for example, few people have the guts, rebalancing discipline, or a nudgy-enough financial advisor to remind them that their allocation is out of whack. Simple rebalancing will help correct that whack.
We get scared to buy something down 12 percent. After Year 2, we also have a hard time selling something that just soared 18 percent in a year. “Ride that winner!” we tell ourselves, to our later regret.

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