Should You Rebalance?
With the markets down significantly most people’s portfolios have drifted away from their target allocations. For those brave enough to look at their porfolios right now, a natural question is should I rebalance to bring my portfolio back to its target allocations. This is an attempt to help answer that question.
- Managing Risk — When equities appreciate significantly they become a larger and larger percentage of your portfolio. Rebalancing helps constrain the risk exposure when the inevitable downdraft occurs. On the flip side it can also help prevent your portfolio from becoming too conservative where it may no longer be able to generate the returns necessary to support your goals.
- Overcoming Bias — Our brains are hardwired to buy high and sell low (i.e., follow the crowd and trends). Sticking to a strict rebalancing discipline forces you to sell high and buy low helping you overcome this weakness.
- Improving Returns — In the short term equities tend to keep moving in their current direction (i.e., momentum), but over the long term equities tend to revert back to their means. A good rebalancing methodology can help you capture some benefits from these tendencies.
The simplest form of rebalancing is to set up target allocations that you reset your portfolio to once a year. For example, if you had a 50%/50% stock/bond allocations on a $100K portfolio, you would start with $50K in stocks and $50K in bonds. If stocks went up 20% during the year and bonds stayed flat, you would then have $60K in stocks and $50K in bonds for a total of $110K. You would move $5K from stocks to bonds to rebalance so that you would have $55K in both stocks and bonds.
Gobind Daryananand, in his paper “Opportunistic Rebalancing“, showed that if you were willing to adopt a more complicted rebalancing strategy, you could potentially pick up another 0.25% in returns over the long run. His strategy was as follows.
Just like in the simple case, the first step is to establish your target allocations. He then suggests you create rebalancing bands of 20% around your targets. Going back to our 50%/50% allocations, this would mean our rebalancing band would be 10% (which is 20% of 50%) above and below 50%. So if the stock or bond went allocation went above 60% or below 40% it would be time to rebalance.
To get the full benefit of this technique you need to check whether the portfolio has gone outside of the rebalancing bounds at least once every two weeks. And lastly, when you do rebalance, only rebalance back to halfway between the target and the rebalance bound. For example, if stocks had gone to 60%, you would rebalance them down to 55% (midpoint between target and rebalance boundary) instead of 50% (the target).
Withdrawals — If you are currently living off your portfolio (i.e., making withdrawals) and you find yourself in the situation where you would be moving money from bonds to equities, redo your rebalancing calculations first reducing the amount in bonds by your annual withdrawal amount. This avoids putting money back into stocks, only finding you need to sell them again to raise money for your withdrawals.
Too Fearful — During severe downdrafts like we are currently experiencing you may discover that your tolerance for risk is not as high as you thought. If that is the case, you may want to change your target allocation to something in between where is was and the current allocation. But be warned, this is giving in to the natural tendency of your brain to be too fearful and too confident. If you go this route, make sure you write yourself a long note about exactly how you are feeling right now, so that when markets are booming again, you can go back and read it to avoid raising your allocation back up again.
So choose your method depending on the level of attention you are willing to allocate to your portfolio and then stick to the discipline. The more you try to guess the “right” time to rebalance the more likely it will be your emotions making the decision.