Rebalance to Manage Risk

In a recent New York Times article, we shared our perspective that rebalancing serves an essential purpose—to manage risk. Adjusting a portfolio’s composition to maintain a desired asset mix is an important aspect of portfolio management and one that requires great discipline.

The reward for such discipline? Lower risk and potentially higher returns over the long term.

Disciplined Rebalancing

Let’s start at the beginning. An investor adopts a long-term asset allocation appropriate to their goals, time horizon and income needs. Their next, and necessary, step is to establish a rebalancing strategy. Why? Returns will vary across the portfolio’s component pieces over time, moving the actual mix away from the target mix. Rebalancing is simply the process of periodically restoring the portfolio’s initial mix.

Take, for example, an investor named Mary. At the beginning of the year, Mary builds a basic portfolio of two asset classes, with 60% targeted to stocks and 40% to bonds. Over time, assuming no rebalancing has taken place, the portfolio’s allocation could easily drift to 80% stocks and 20% bonds due to stocks’ strong performance.

While Mary will have certainly benefited from the growing allocation to stocks, the portfolio will also be much riskier than initially constructed. That’s because left alone, a portfolio that is never rebalanced will become more skewed toward the highest-returning asset class.

If this riskier portfolio were appropriate for Mary, we’d argue it should have been implemented in the first place. So, unless something material has changed with Mary’s personal circumstances, the portfolio should be rebalanced to its target mix, re-aligning its risk profile to Mary’s goals and objectives.

Using a threshold approach, we allow a portfolio’s asset classes to fluctuate within a range of 80% to 120% of target. Rebalancing back to the target mix occurs once the minimum or maximum threshold has been exceeded. For Mary, this means the portfolio would have been rebalanced back to target when stocks exceeded 72% of her portfolio (a 20% increase from 60%). Had stocks fallen below 48% of the portfolio’s weight, bonds would have been sold—and stocks purchased—to maintain fidelity to the agreed-upon mix.

Buy Low, Sell High

This sounds reasonable enough, but it is rarely easy. Investors too often believe what has done well recently will continue to do well, and what has done poorly will continue to underperform.  A disciplined rebalancing strategy, which requires selling winners and buying losers, is almost always difficult in practice.

To overcome the discomfort, it’s best to think of rebalancing instead as adhering to the investment ideal—buy low and sell high. A disciplined rebalancing strategy seeks to help investors control risk, stay the course, and have a better, long-term investment experience.

Simple, but not easy.