Indianapolis Office
Kathleen Hartman, CFP, CFA
317-576-1727
khartman@greenleaf-fg.com

The Whys and Wherefores of Rebalancing

Rebalancing an investment portfolio is difficult for many investors.  By selling shares of your portfolio's best-performing asset class and buying shares of an underperforming asset class, you must have the conviction it takes to sell some of your "winners" and buy more of your "losers." 

Although it sounds counter-intuitive, the process of selling high and buying low is fundamentally important for risk management and studies show that it provides better returns, as well.

Why Rebalance?
For example, an investor with a 60% stock, 40% bond allocation in 2003 would have seen diverging results in her two broad asset classes.  From 2003 to 2007, the U.S. stock market experienced an average annual return of 16.3%, compared with 3.6% for the U.S. bond market.  The investor's stock position therefore grew proportionately larger during this period, while the bond position shrank as a percentage of the whole.

Without any rebalancing, the investor would have then experienced the severe declines of the 2008 bear market with a stock allocation well above her 60% target.  Consequently, the investor's bear-market losses are much larger and the recovery time much longer.

How Often Should You Rebalance?
Clearly, rebalancing has many merits.  But when do you do it? Vanguard's recent study, "Best Practices for Portfolio Rebalancing" looks at the optimal rebalancing frequency in light of taxes and transaction costs. 

Institutions, such as pensions and endowments, do not have to worry about taxes and their trading costs are extremely small. Individuals, however, pay capital gains taxes in certain accounts, they have brokerage commissions and bid-ask spreads to consider, among other possible fees and issues.  Rebalancing is also a time-consuming and labor-intensive process.

Therefore, for individual investors, the Vanguard study recommends regular monitoring (semi-annually or annually) and a threshold of about 5 percentage points.  For the 60/40 investor, then, rebalancing is wise when the stock position reaches 65% or the bond position reaches 45%. 

Great Rebalancing Opportunities
Vanguard's study notes that although the average annualized return of equities from 1926 through 2009 was 9.9%, the annual return of stocks ranged from -43% to +54% during that time. Stocks turned in a calendar year loss approximately one out of every four years.

With this much volatility, would investors be rebalancing constantly?  In fact, the authors suggest that there were seven times when bonds did so well that investors should have rebalanced into stocks -- in 1930, 1931, 1937, 1974, 2000, 2002, and 2008.  However, buying stocks in 2008 was something that very few people were willing to do.

Conclusion
Since rebalancing is about risk management, first and foremost, it is most important to rebalance out of stocks and into bonds.  Those who can also rebalance into stocks and out of bonds will likely have better results with this disciplined approach. Ultimately, while Vanguard's study is a helpful guide, each investor should both invest and rebalance in a manner that matches their risk capacity, income needs, and other personal considerations.