History shows that stocks have outperformed bonds over the long term. So it makes sense for long-term investors to put their money in stocks. My belief has been that investors with more than twenty years until retirement should have all of their retirement savings invested in stocks or stock mutual funds. Some investment professionals recommend that people with twenty, thirty, or even forty years until retirement should invest a portion of their retirement savings in bonds. They proclaim that holding some bonds in a long-term portfolio can be used to reduce risk and improve performance. This advantage can be achieved through rebalancing after periods of market fluctuation.
Rebalancing is the transferring of money within a portfolio of investments to return the portfolio allocation to a predetermined, desired asset allocation. For example, Ronald wants his portfolio to contain 60% stocks and 40% bonds. After a period of great stock performance, the values of his stock holdings increase relative to his bond holdings, resulting in a portfolio valued with 70% stocks and 30% bonds. Ronald would need to rebalance his portfolio by taking some money from his stocks and moving that money to his bonds so that he could regain his desired allocation of 60% stocks and 40% bonds.
Rebalancing facilitates the process of buying securities at lower prices and selling securities at higher prices. Rebalancing does not require the investor to add new money to the portfolio. When Ronald needed to rebalance his 70% stocks and 30% bonds portfolio to achieve an allocation of 60% stocks and 40% bonds, he sold some of his stock holdings and used those proceeds to buy more bond holdings. Because the stocks had performed well relative to bonds, the stock prices were higher when he sold his stocks, and the bond prices were lower when he bought more bonds. Buying securities at low prices and selling those securities at high prices should result in a profit.
The rebalancing concept is related to portfolio diversification. No one asset class will consistently beat all others, so some investors diversify their portfolios among different asset classes. The percentage allocation to each asset class partly depends on the investor’s time horizon and risk tolerance. The time horizon and risk tolerance are usually directly related to the percentage invested in stocks. When investment performance skews the actual allocation from the intended allocation, the portfolio allocation may become more or less risky than the investor desires. By regularly rebalancing the portfolio, the investor will maintain his desired risk exposure.
Asset allocation can also be evaluated on a more detailed level within the asset classes of stocks and bonds. Investors may want a certain percentage of their portfolio allocated to international stocks versus domestic stocks or a certain allocation to long term bonds versus short term bonds. The same concept of rebalancing can be applied to any investments within a portfolio. Portfolios with a wide variety of investment holdings can benefit most from rebalancing. Uncorrelated or inversely correlated assets within a portfolio will cause more volatility for the percentage allocated to each asset.
Investors who are in the accumulation phase may want to take an alternative approach for rebalancing. Rather than selling high and buying low, rebalance by just buying more of what is low. For example, Floyd has a retirement account allocation of 80% domestic stocks and 20% international stocks. Over a given time period, international stocks perform better than domestic stocks, causing Floyd’s retirement account to become 75% domestic and 25% international. In order to rebalance his account, Floyd temporarily invests all new contributions in domestic stocks until his account rebalances. Once his account rebalances to 80% domestic and 20% international, Floyd can revert to contributing to both assets. The reverse of this strategy could apply to investors making regular withdrawals from their accounts. They would withdrawal only from the asset that is over-allocated until the overall portfolio regains the appropriate allocation.
The advantage of rebalancing depends on market fluctuations during the investment holding period. As an example, Lenard evenly splits his portfolio between a conservative investment and an aggressive investment. The aggressive investment performs better during up markets, and the conservative investment performs better during down markets. In year one, Lenard experiences an up market, and his aggressive investment grows to more than 50% of his portfolio. He moves the excess amount in the aggressive investment to the conservative investment to make his overall portfolio more conservative. In year two, Lenard experiences a down market. Because he rebalanced to become more conservative after year one, Lenard’s portfolio does not decline as much in year two. If Lenard had not rebalanced after year one, he would have had a bigger loss in year two.
This same principal could also apply in reverse. If year one happened to be the down year, Lenard’s aggressive investment would decline to less than 50% of his portfolio. Lenard rebalances by moving the excess amount in the conservative investment to the aggressive investment to make his overall portfolio more aggressive. Lenard experiences an up market in year two. Because he rebalanced to become more aggressive after year one, Lenard’s portfolio grows more in year two compared to if he had not rebalanced at all. As this example demonstrates, opposing market fluctuations must be assumed for the rebalancing strategy to produce greater returns.
Rebalancing is an easy and low-cost way to maintain an investor’s desired asset allocation and risk exposure in any diversified portfolio. Investors should survey their portfolios at least once per year to see if their portfolios have become unbalanced. Investors should remember to consider transaction fees when deciding on the frequency of rebalancing. Rebalancing can be done on a regularly scheduled basis or be discretionarily based on market conditions. The most important time to rebalance is after major market movements when allocations can be off by 10% or more. Rebalancing hinges on the simple principal of buying low and selling high. Regardless of time horizon or risk tolerance, rebalancing can produce benefits on which every investor should attempt to capitalize.
