Rebalancing asset allocations

Very few private investors give much thought to asset allocation, even though it’s far more important than picking stocks or funds in determining your investment returns.

Even worse, those who do set up a nicely diversified portfolio often forget all about their ideal asset mix once they’ve made their initial decisions!

This is foolish, and potentially bad for your wealth, since like this you’re leaving asset allocation to the whims of the market.

Often the only time people wonder whether they should have rebalanced is when a big bear market slices more money off their net wealth in six months than they’d ever imagined possible.

If you’ve diversified your portfolio into different assets to reduce its volatility and improve its risk/return characteristics, it makes no sense to abandon that just because one asset class has boomed and another slumped.

Instead, periodically rebalancing your portfolio by selling down winning assets to buy more of under-performing assets can boost your returns, help keep volatility closer to your own tolerance levels, and reduce the risk of your portfolio being exposed to bubble markets.

In gambling terms (not that we’re gambling, we’re investing!) it enables you to take some money off the table.

Rebalancing: Why you should do it

Let’s say you’ve decided on a very simple asset allocation, splitting your money between equities and government bonds on a 50:50 ratio.

Imagine for illustration that due to a 12-month stock market rally, the value of your equities soars 50%, while your bonds fall in value by 50%.

The ratio of your split between equities and bonds is now 75:25, or 3:1.

In other words, you’ve no longer got a balance between equities and bonds, but rather a huge imbalance towards equities.

So what, you might think? Don’t they say you should “run your winners?”

True, but if you were comfortable with a 3:1 equity-to-bond ratio, you should have set that up in the first place, not allowed the market to lure you into it. The expected return of equities is higher than bonds, but the cost is greater volatility. Presumably you were holding bonds because you wanted to dampen down big swings in your portfolio’s value?

The next stage of our illustrative fable is pretty predictable.

Suppose the value of your equities now falls 50% in a year-long bear market. Generally, government bonds will rally in such circumstances. So your diminished holding of bonds provides some solace, but not as much as if you’d maintained your 50:50 weighting.

The conclusion: You can’t bare to tell your husband/wife that your portfolio lost so much in one year, so you pretend you spent it on wild romps with a stunning young lady from Las Vegas.

If you’re a female Monevator reader, perhaps your husband isn’t so upset as he might be, but you get my point.

What if you’d rebalanced after the equity boom?

Imagine instead you’ve sold down some of your winnings in equities after 12 months and put the proceeds into your diminished bond portfolio, sufficient to bring your portfolio back towards a 50:50 split.

When the bear market comes, you still lose money; equities tend to fall harder than government bonds will rise. But overall your position isn’t half as bad. You might even be able to afford to take that lady from Vegas to dinner!

Rebalancing isn’t a free lunch

The point of that illustration isn’t to say you should have a 50:50 split between equities and bonds, of course, and certainly not to say markets always rally and then fall back so neatly and predictably. (If only!)

Rather, it was to show the essential benefit to rebalancing; to reduce your portfolio volatility by ‘dampening’ the extremes of bull markets and bear markets in different assets.

Better still, some studies have shown you can get improved returns in some circumstances by rebalancing your portfolio.

In his excellent book Unconventional Success (U.S. link), Yale University’s chief investment officer David Swensen shows how rebalancing a portfolio during the 1990s and the turn of the century would have left a real-life tranche of fairly sophisticated investors slightly better off – even though it would have reduced their opportunity to benefit from the tech bubble.

The pay-off, naturally, came when rebalanced portfolios fell less hard in the subsequent dotcom crash.

Nevertheless, understand that rebalancing will likely stop your portfolio hitting the heights that it might do if you always let bull markets in particular asset classes pump your portfolio up, rather than top-slicing and selling down out-sized allocations by rebalancing.

If you had perfect market timing, you could make more money by riding bull markets and swapping out your money at the very last moment. However virtually no one can do this, and if they can, they can’t do it twice. Forget it!

For mere mortals, rebalancing is a sensible compromise in terms of returns, and a must-do in terms of keeping your portfolio as risky as you actually want it to be.

Rebalancing in practice

When I say rebalancing isn’t a free lunch, I don’t just mean in terms of dampening your returns.

Rebalancing also increases your transaction costs from trading, and unless you’re careful it can trigger tax liabilities.

It also exacts a psychological toll.

Reading this article you may be thinking it all sounds logical enough, but in reality it’s very hard to keep a cool head and sell the hot asset everyone is gushing about to buy the one that’s falling in value, especially as such trends can run for years.

I’ve ended up with a portfolio consisting almost entirely of equities, for instance, after I sold my modest bond holdings too early in 2008.

I don’t mind particularly. I’ve a very high risk tolerance, and am still young enough to stomach wild plunges downwards in my net wealth, even if I feel guilty about it! I’m usually very overweight in equities, balanced mainly by cash, though after this bear market I’ll definitely consider adding some government bonds when they’re better value.

But if I’d been a retired investor living off dividend income, this strategy could have been disastrous.

I’ll explore the practicalities of rebalancing in a future post on Monevator, so please do bookmark the site or subscribe for some practical steps on keeping your assets in balance.

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How to rebalance your portfolio