Rebalancing 101: The What, Why, When & How

Rebalancing 101: The What, Why, When & How

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Do you ever rebalance your portfolio?

That might seem like an odd question, but as with many aspects of investing, our experience with new clients who come to us is that this is something which in theory is simple, but in practice is not easy.

As a result, rebalancing can often be relegated to the drawer marked ‘Things I know I should do, but I’m not sure where to start’.

So, let’s look at the basics – what is rebalancing; why should you do it; when should you do it; and how should you do it.

What is rebalancing?

Rebalancing simply means periodically adjusting the amount of your portfolio exposed to growth assets (equities) and defensive assets (bonds) as the value of the assets fluctuates over time.

For example, if you originally constructed your portfolio so that 60% was invested in equities and 40% in bonds, over time those percentages will drift, depending on whether markets are rising or falling.

If stockmarkets have been rising, you might find that your portfolio drifts to a 70/30 portfolio rather than a 60/40, in which case you would need to sell some of your equity assets and buy more bonds to restore your portfolio to its target asset allocation.  Conversely, if markets have fallen, your 60/40 portfolio might now be a 50/50 portfolio, meaning you must sell some bonds and buy more equities (in practice this is probably the hardest part of rebalancing*).

Ok, this is where we might hit our first obstacle. Sadly, a lot of investors don’t even think about the ‘balance’ of their portfolio, instead relying on a haphazard approach to making their investment decisions based on who the latest star fund manager is, or which asset class is currently being hyped up in the financial media.

So, before you can think about rebalancing, you might first need to take a long hard look at your current portfolio, work out how much is currently allocated to equities and bonds and ask yourself ‘Is this the right asset allocation for me?’.  If it isn’t, sort that out first.

Why rebalance?

Contrary to what you might read about the topic, the primary purpose of rebalancing is NOT to enhance your investment returns. In fact, the evidence shows that rebalancing is more likely to slightly reduce your returns. Sometimes, an excess return might be generated, known as a ‘rebalancing bonus’, but this should never be the principal motivation for rebalancing.

The fundamental reason for rebalancing is to maintain the appropriate level of risk in your portfolio. Seeing your portfolio drift from a 60/40 allocation to 70/30 might tempt you to do nothing, because who wouldn’t want to ride that rise and enjoy watching their portfolio increase in value?  That’s fine – as long as you can pinpoint precisely the date on which markets will turn and reduce your equity allocation just before that happens. Which, of course, you can’t.

The truth is, if you let your portfolio continue to drift in a rising market, at some point the level of exposure to equities will be higher than you can tolerate emotionally. Which means that when markets do turn, you are more likely to panic and bail out of the market at precisely the wrong time.

Please don’t kid yourself this won’t happen to you. Unless of course you have a massive emotional tolerance to risk, which some of us might think we do, but when push comes to shove few of us really do.

At some point in your investing lifetime (and probably more than once) you are going to experience market conditions like this:

Source: DFA Returns

*During the above time period I rebalanced our clients’ portfolios every month for more than six months – all the way down to the bottom of the market trough (and back up the other side).  As markets continued to fall, and fall, I found it increasingly stressful to execute our rebalancing process – and this wasn’t my money!

Remember, that when you rebalance you are going to be selling what has risen in value and buying more of what has either fallen in value or not changed in value. In other words, you’ll be employing a discipline of ‘buy low, sell high’.  You’ll be doing exactly the opposite of what most market participants are doing. Going against the herd is counterintuitive for us, but essential if you want to have a successful investment experience.

When should you rebalance?

 There’s no one right answer to this question. You could rebalance once a quarter, once a year, at the beginning or the end of the year, or on your birthday!  When you rebalance is not nearly as important as simply having a process in place to do so.

For most individual investors, an annual rebalance will be sufficient in most years. However, when we see another major market downturn (and recovery) as we saw in 2008/09, once a year may not be enough.

At Bloomsbury, we employ a rules-based process with client portfolios reviewed regularly and rebalanced when the weightings of component parts deviate significantly from their targets. It’s because we use a target asset allocation, with a set tolerance level, that we needed to rebalance so frequently during 2008/09, both as markets were falling, and again when markets recovered.  We bought equities cheap on the way down and banked gains as they increased in value (‘buy low, sell high’).

How do I rebalance?

 Firstly, you need to work out which of your assets are out of kilter. Ideally, you have a target asset allocation not only for your overall portfolio (e.g. 60/40) but for the individual components within it.

All investment platforms should be able to provide you with a valuation report showing your asset allocation. Many can also measure that against a model asset allocation so that you can easily identify the trades you need to execute, and some may even offer automatic rebalancing so that the required effort on your part is minimal.

Alternatively, a bit of knowledge of Excel will enable you to do the same thing yourself.

If having considered all the above, you don’t feel confident in being able to implement a robust rebalancing process and – more importantly – to stick with it through thick and thin, then don’t despair.  You could consider investing in one, low cost, globally diversified index fund which will maintain your chosen asset allocation for you. There are several fund managers who offer these funds.

Whether you choose to do it yourself, work with a financial planner or wealth manager, or outsource it to a fund manager, just do it.

For more information on constructing investment portfolios, you can download our Guide to Investing, free of charge, here.