The What, How, and Why of Rebalancing
Risk and volatility, continued
Recently I’ve spent a lot of time talking about risk and volatility. While there are so many important parts to investing, I felt as though risk and volatility deserved some extra thought and attention. Both are difficult ideas to grasp and, once understood, even more difficult to accept as part of the plan. They are always present, pulling back on our investments, making us panic along the journey to our goals, and at their worst, scaring us from investing in the first place.
This is the last article in my series on risk and volatility. Feel free to read on, but in case you want to start from the beginning, you can find the rest of series here:
1) About Risk
3) Risk Realized & the Goal Window
In these articles you will find a better way to accept risk, avoid unnecessary risk, accept volatility, and use dollar cost averaging to minimize/take advantage of volatility. All of these are critical steps towards a long, successful experience in investing.
Now for the last step: rebalancing.
Volatility reviewed
In past articles we’ve spent time discussing volatility and how it can affect our investments and, more critically, cause us to act irrationally during unexpected turmoil. The important notes from our discussions are:
1) Volatility will be a part of nearly every single investment you make.
2) The more return you expect from your investment, the more volatility you should be willing to accept.
3) Volatility represents unrealized gains and losses. It only exists on paper. Selling your investments will make losses or gains real. This is when volatility turns into risk.
4) Dollar cost averaging can help smooth out the ride. Buying regular amounts at regular intervals ensures a more reasonable overall cost for your investments.
The next tool
While dollar cost averaging is a great tool to combat volatility, there is another tactic we can use along the way. Just as DCA helps us reduce the effects of volatility, we can use DCA in tandem with another strategy to make the effects even stronger. This powerful next tool is portfolio rebalancing. By using portfolio rebalancing, not only will we be able to further mute the effects of volatility, but we can actually use the movements of the market in our favor. Even better; it is a simple concept, easy to implement, and easy to follow year after year.
First: Choosing a diversified portfolio
As mentioned, the concept of rebalancing is simple and easy to follow. That said, the most difficult part is the first step: creating a well diversified portfolio that aligns with your risk tolerance and goals. This can be a difficult task for many but some diligent research can help you make some informed decisions. As always, hiring a qualified financial planner is your surest bet in creating a portfolio that works for you.
Note: To maximize the effects of rebalancing, some elements of your portfolio should have low correlation to each other. Low correlation means they do not move up and down at the same time. For contrast, highly correlated investments would be a S&P 500 index fund and a Dow Jones index fund. These investments will have very similar movements and have a high correlation. Some common investments that have a lower correlation to stocks are bonds, commodities, collectibles, real estate, and international investments. Here is a helpful chart from portfolio visualizer to help you decide. Correlation is measured from 1.00 to -1.00 (highest to lowest). Before you go it alone, reach out to set up an initial meeting.
Setting the stage for rebalancing
Once you have decided on a diversified portfolio, you’re ready to implement the strategy of rebalancing.
For an example, let’s say you decide on a very simple portfolio allocation of 80% stocks and 20% bonds. You decide to use a total S&P 500 index fund for your stock portion and a total US bond market fund for your bonds. We see from this chart that these investments have a relatively low correlation of 0.25. With a correlation of 0.25, sometimes these investments will move together, but most of the time they will move independent and unrelated to one another.
You decide to begin your investment with $10,000. Since we are using a 80/20 allocation you would put $8,000 in the S&P 500 and $2,000 in bonds. All set. Now the easy part, we let time do its thing.
Let’s say the stock market has a return on 10% this year while the bond market stays flat. After a year, you now have a balance of $8,800 in stocks and $2,000 in bonds. This represents an overall return of 8%.
Back to the starting line
In order to rebalance our portfolio, we just need to apply a little math.
If your goals haven’t changed, then there is likely no need to stray from your 80/20 portfolio. Of course, if life events or age related factors warrant, you can always change to a different allocation. In that case, choose and use your new percentage and go from there. For now we’ll stick with 80/20
The first step is to add together the value of your investments. In our example you have a balance of $10,800
Now multiply the total by the desired percentages (80/20). You now have a new target portfolio balance of $8,640 stocks and $2,160 bonds.
Comparing the target amounts to your current balances of $8,800 and $2,000, you need to make a trade to bring your portfolio back into balance. By selling $160 of your stock fund and buying $160 of the bond fund, you’re able to quickly bring your portfolio back to the 80/20 balance. Congratulations! Rebalancing complete!
Buying low, selling high
There are a number of benefits to rebalancing your portfolio regularly. One of the benefits is the natural effect of buying low and selling high.
Buying good investments low, holding them, and hopefully selling them at a higher price in the future is a universal goal in investing. Of course this is easier said than done; even the best informed investment decisions are not guaranteed and ultimately there is no way to see the future. Simply, over time, no one beats the market.
But with rebalancing, we are doing this constantly. Notice in our example above, we were able to sell $160 of the $800 gain in stocks, effectively locking in that gain, and re-investing in a bond market that could be due for growth. What if the bond market had lost value? Even better… we end up selling stocks at a gain and buying more bonds at an even lower price. Of course there are years where both investments will be up or down (this happens approximately 1 in 5 years for stocks and bonds). This is fine, just re-apply the same rebalancing technique above and move on.
Other results
Over the long run, rebalancing has many other benefits to your portfolio.
First, as seen above, by constantly selling high and buying low, we’re able to smooth out the returns of your different asset classes. This is probably the most beneficial side effect of rebalancing. Smoothing out the returns not only diminishes volatility, but gives us a strategy in down years to prevent us from making more harmful, drastic decisions.
Rebalancing also keeps our investments focused on what’s most important. Since we’re investing with some important goal in mind (retirement, education, etc), we’re able to keep the investment allocation balanced according to plan. As returns rise and fall, the drift can make us lose focus on these goals. Rebalancing can remind us why we’re doing this in the first place.
Keeping our portfolio in line with our personal risk tolerance is another great benefit. If more volatile investments do better over a year, we might end up with a portfolio that is too risky for our personal tastes. Rebalancing helps bring the portfolio back to a palatable risk profile year after year.
The long term
While rebalancing has wonderful intermediate effects and can smooth out returns over the life of an investment, there are trade-offs that should be considered. The benefit of rebalancing is that it mutes volatility and creates more consistent returns year over year. Unfortunately, the trade-off for this benefit is slightly lower overall long term returns. It has been shown that frequent rebalancing can create slightly lower long term returns as a side effect to the benefit of lower volatility (this makes sense with what we know about how risk and return are related). However, while rebalancing creates slightly lower returns, these returns are still better than if you chose a single investment with lower volatility to begin with. If you’re curious, here is a very good read on how this plays out.
The bottom line, with rebalancing, we know that there is a cost in returns for the benefit of lower volatility. If you have a longer time horizon, work with your financial planner to determine if less frequent rebalancing is more appropriate for you portfolio.
Incorporate dollar cost averaging
Finally, in the effort to reduce volatility, you can incorporate dollar cost averaging. If you read my last article, you know that dollar cost averaging is a great way to prevent volatility. DCA achieves this by smoothing out the cost of investments over each month (or whatever time period you choose). This creates a reasonable cost for your investments while also encouraging healthy, consistent investments behaviors overall.
There are a few ways to incorporate DCA along with rebalancing. The simplest way is to allocate each contribution according to your strategy and rebalance the portfolio directly each year. Given our example above (80/20 stocks/bonds), let’s imagine you are investing $100 a month. In this case you would invest $80 dollars into stocks and $20 in bonds each month and then execute rebalancing every so often to make sure your allocation remains in balance. This type of strategy is the least complicated and helps encourage a more regular, hands off approach to investing. Many financial institutions offer automatic rebalancing along with automatic contributions. Set it and forget it.
A more complicated strategy would be to allocate each month’s contribution in such a way that helps bring your allocation back in balance. For the example above, after a year of returns we are left with $8,800 in stocks and $2,000 in bonds. If we are contributing $100 the next month, we might choose to allocate all $100 to bonds, bringing our balance closer to 80/20 (~81/19). The tricky part to this strategy is that this would need to be calculated each month. This would be ideal for someone with established investing behaviors and enjoys the act of managing the portfolio regularly.
