Portfolio Rebalancing: What is it? Why Bother?

Some tasks cause decision paralysis amongst those making the jump into DIY investing. One is determining their risk tolerance and asset allocation. Another is deciding which funds to buy in what accounts to achieve that in a tax-efficient way. I have made a simple three-fund portfolio building tool and a more complex one to help with that. The specter of another portfolio management task can stop people before they even start – fear of rebalancing.

This post and the next few will shine some light onto this beast and hopefully make it less scary. I am also making an online tool to help make the mathematics of the task simple. Even across account types.

What is investment portfolio rebalancing?

When we set up our investment accounts, we diligently choose an asset allocation to suit our needs. That includes as much equity as we can stomach to maximize long-term investment returns, tempered by enough bonds to smooth the volatility so that our emotional investor beast doesn’t get provoked and smash the portfolio. We also buy different types of equities to minimize investment risk through diversification.

Unfortunately, our investments then grow at different rates and that nicely constructed asset allocation drifts out of alignment over time. More sedate bonds tend to grow more slowly while equities can grow rapidly and have periods where they can drop spectacularly. Even different holdings that will grow at similar rates in the long-run, have periods of growth and retraction at different times.

Rebalancing is a combination of buying some of the laggards and sometimes selling some of the winners in our portfolio to bring our asset allocation back to where we intend it to be.

That can be simple, like within a single account. It could also be more complex, such as rebalancing across different accounts to keep an overall asset allocation for the total portfolio. The math behind that and fear of tax consequences from selling are what often cause people to hesitate. However, even that can be simplified – especially during the accumulation years. The mechanics of when and how to do that will be future posts.

Why bother rebalancing an investment portfolio?

The biggest reason to rebalance is to maintain your desired level of risk.

Equities generally return more than bonds over the long run (~10%/yr vs ~4%/yr over the past 90 years of U.S. data). If left unchecked, your equity allocation would eventually dwarf the bonds allocation. Equities are expected to return more since they have more risk. So, as the equities grow and take over your portfolio, the level of risk (and volatile price swings) would also increase over time. Usually, we want the exact opposite of that.

Volatility is riskier as we age. Not just because of coronary artery disease.

As we age, we have less human capital to spend to absorb losses or time to wait for the markets to recover before we need the money to live on. Imagine that you have built a big enough portfolio to retire on and it crashes just as you plan to kick-back and access it. You may need to either live on less or delay retirement until the market recovers.

That may seem like a distant problem to someone starting out. However, the odds of something happening to force an unplanned partial or full retirement also increases once we are “over the hill”. So, deferring rebalancing until closer to your planned retirement becomes increasingly unwise.

Portfolio rebalancing forces us to sell investments high and buy low.

“Buy low and sell high” sounds like a guaranteed recipe for investing success. However, our behavioral hard-wiring makes it hard for us to sell what is doing well (we desire more of it) and pushes us to sell what is lagging (to make the pain stop).

A mechanical approach to rebalancing, with the discipline to follow it, should overcome that. It directs us to sell the assets whose growth has outpaced the others and buy the laggards to bring our allocations back into target. Even with mechanical rebalancing, the results of that in practice are actually more variable.

Rebalancing can increase returns in volatile markets and decrease them in smooth trending markets.

The relative performance of rebalancing is heavily influenced by the time-frame that you look at. For example, in the long-term, equities are expected to outperform bonds. So, you would be selling equities to buy more bonds with rebalancing. That keeps your allocation steady and avoids the growing risk already illustrated in the chart shown above.

Over the long-term

You would be constantly decreasing the proportion of investments in your portfolio destined to be bigger winners to buy more of those destined to lag over the long-haul. Therefor, the averaged result would actually be a lower long-term return. Looking at the long-range chart below, the market goes through long periods of smooth upward trending (like 1975-2000) and choppy periods (like 1965-1975 or 2000-2015).

In the shorter-term

Volatility is higher over shorter time frames. If we hone in and compare a trending decade to a choppy “wild ride” one, we can see a monthly rebalancing strategy outperform or under-perform. Either way, the difference is small. Even more importantly, no one knows what type of market lies ahead.

You can cherry-pick different time frames to show different results. In addition to a trending versus volatile market in the periods that I highlighted above, another factor was at play. During the 1990s, bond prices and equity prices were positively correlated. Conversely, during the wild 2000s, they were inversely correlated. This means that they fluctuated in opposite directions, setting up a better rebalancing situation between equity and bonds during the 2000s.

Rebalancing may improve returns more for assets that have similar expected returns but are still only weakly correlated.

A good example of this are stocks or markets with similar risk/return profiles, but in totally unrelated sectors. They would be expected to have similar returns over the long-term. However, they would fluctuate and move differently in the short term.

With index ETF investing, it could be equity indexes that cover regions that have similar expected risk and return, but are influenced by different forces and perform differently over the short-term. The TSX and S&P 500 are a good example, as illustrated below over a 30 year period that encompasses both smooth and volatile markets.

Rebalancing re-inforces disciplined investing.

As stated at the beginning of this post, the biggest reason to rebalance a portfolio is to manage risk. The biggest risk that rebalancing helps us with is the behavioral risk. The above historical models assume perfect investor behavior. In reality, investors usually lag those ideal returns due to fees, taxes, and bad behavior. The behavioral gap can average up to 2%/yr for investors as a whole with more volatile investments or market environments. Individually, it could be infinite if we make a big mistake. There are two ways that rebalancing helps manage behavior.

First, it helps to control volatility by keeping our equities from taking over as already illustrated. Volatility tickles the toes of our inner Hulk Investors. Unwise. Second, it enforces discipline to not try to time the market.

Market-timing is intuitively attractive but practically difficult. With our emotions in play – it is even worse.

Timing the market can be overt, like selling things that you think are about to drop with the plan to buy them back later for less (shorting the market). A bad idea for most DIY investors for many reasons beyond the scope of this article.

Market timing attempts can also be more subtle, like delaying a contribution and sitting on cash for the same reasons. “The market just made a new high. So, it is bound to drop soon (since it fluctuates) and I will buy then” is a common rationalization. I have definitely fallen victim to this one.

The problem is that rising markets will constantly be making new highs and it is impossible to know which one is going to be the last one before a drop. Markets rise more often than they fall over time, so the odds are not in your favor of picking a top. The path to the bottom in a declining market is also not a straight one, making picking the bottom difficult. Successful market-timing requires that you get both tops and bottoms right.

Rebalancing can combat our behavioral misdeeds by being simple and mechanical.

Mechanical rebalancing occurs when a pre-defined trigger is struck. When that rebalancing trigger is tripped, it must also be acted upon. That means that it needs to be a simple process. It also means that we should consider in advance what approach to rebalancing we want to use.

There are different rebalancing triggers and methods to choose from.

These must weigh the benefits of rebalancing, as outlined in this post, against the potential downside of incurring extra transaction fees, burning time and brain cells, or triggering capital gains taxes. We’ll consider how often and precisely we should rebalance in the next post.