Portfolio rebalancing is an effective risk control strategy that should occupy a leading role in the management of every investor’s portfolio. Large institutional investors such as university endowments religiously rebalance their portfolios to bring allocations back in line with their original design. Unfortunately, individuals and advisors often allow emotions to override this time-tested and sensible investment policy, often with unpleasant results.
A broad consensus exists among investment theorists that a portfolio’s asset allocation - the mix of stocks, bonds and cash – is the main determinant of both the risk and returns the investor will experience. Over time, different assets produce different returns; therefore, the allocation can drift considerably from its original target. It is especially true during periods of very robust or very meagre performance in a particular asset class. The result can be a portfolio that has changed significantly from the original and is now inconsistent with an investor’s goals and expectations. Rebalancing allows an individual to periodically realign the portfolio with those goals and expectations.
Despite compelling research and empirical evidence supporting the practice, most investors fail to rebalance their portfolio. Why? Rebalancing runs counter to our emotions, requiring exceptional fortitude to sell assets that have generated the highest returns and use the proceeds to buy assets that have caused the most disappointment. Faced with this opportunity, most investors instead fall prey to their behavioral biases of fear or euphoria, do nothing, and let the markets dictate their investment strategy. Even worse, others fall victim to the lure of the markets’ momentum and herd mentality, dumping the poor performers in order to pile more money into the winners. When markets suffer steep declines as they did during the most recent financial crisis, these investors lose confidence in their plan, sell hard hit investments at fire-sale prices and seek out the safety of cash and bonds.
Portfolio rebalancing is neither free nor a guaranteed strategy for increasing investment returns. It could trigger transaction costs to buy and sell securities and capital gains taxes if executed within a taxable account. While rebalancing systematizes the process of buying low and selling high, it cannot be relied upon to improve returns. The impact on returns depends upon the period being studied. For example, during investment periods when asset classes revert to their averages - price increases are followed by price declines and vice versa, rebalancing can generate superior returns. Conversely, during periods when markets maintain an upward trend, rebalancing may result in inferior returns. Although a large body of research has demonstrated that, over long-time horizons, assets revert back to their average returns, suggesting that rebalancing will often improve investments gains is not a foregone conclusion that it will.
Smart investors understand that rebalancing is a risk control, not a return improvement strategy. Implementing a sensible, unemotional rebalancing policy will yield two important benefits. It will ensure that the integrity of your portfolio is maintained, and it will protect against a powerful force that can impact your wealth: your emotions.
John Spoto is the founder of Sentry Financial Planning in Andover and Danvers. For more information, call 978-475-2533 or visit www.sentryfinancialplanning.com.