The wisdom of rebalancing a portfolio tends to peak investor interest during and after a stock market down draft --- after it’s too late. The basic idea is to sell incremental amounts of our winners as they are going up and add those dollars to our relative losers --- because today’s winners tend to be tomorrow’s losers and vice versa. The problem is that we love our winners and can’t stand to give up even small amounts of them. Those winners, unfortunately, have no idea how much we love them, so they often drop like stones caring little for the damage they do to our self esteem. Only in the aftermath of a major market swoon do we wise up and wish we had kept current what was supposed to be our 50/50 or 70/30 mix of stocks and bonds.
There are two applications for rebalancing with each one offering different advantages and results. There is classic rebalancing that applies to stocks versus bonds described above. Then there is Modern Portfolio Theory calling for rebalancing as applied to all-stock portfolios but that maintains preset percentages between different styles of investment management (large company, small company, foreign, etc.) .
The primary advantage in either case is psychological as much as mathematical. Rebalancing prompts investors to stay committed to a long-term strategy that applies just second-grade arithmetic rather than adopting a process that requires second-guessing the importance of what some pundit might have said on a financial talk show. Anything that removes the possibility of fear and emotion in the investment process --- not to mention greed --- has accomplished something positive.
The efficacy of the stock versus bond rebalancing exercise is treated exhaustively in the latest Dan Wiener publication, “The Independent Advisor for Vanguard Investors.” He points out that two types of rebalancing include time-dependent and asset-imbalance triggers. The former involves just bringing asset amounts back to their preset percentages at specific times --- like once a year. The second calls for rebalancing only when the allocation varies by, say 5% or more. Bottom line is that for the long term investor, stock and bond rebalancing is more about reducing risk and volatility rather than generating higher overall returns over time. The reason for this, based on Wiener’s research, is that rebalancing calls for removing money from stocks that would have generated better returns than bonds over long periods.
Rebalancing an all-stock portfolio is a different story. My book illustrates the results of annually rebalancing a technology fund versus a 500 index fund over a twenty-year period ending in 2012.
Assuming a $10,000 per year contribution, the difference in results created almost $40,000 as a reward for a few key strokes each year to manage the account --- $518,000 versus $479,000.
As a bonus, the process of rebalancing in the all-stock portfolio also created what is a straighter line representing the composite result of both funds together. This line represents the ‘path of minimum regret.” Looking at the results of, say 1999 and then 2000, anyone can see that technology fell into the abyss, but rebalancing between 1995 and 1999 would have trimmed some of this high flyer and created less volatility for the portfolio overall.
How much difference can investment styles among stock funds exhibit? Well, large cap growth funds in 1999 were up 62 percent that year and small cap value funds gained zero. The following year, small cap gained 30 percent while large cap growth lost 30 percent --- and the disparity increased by another 20 percent (on each side) in 2001. When we’re considering stock funds that incorporate different investment styles and types, diversifying and rebalancing reduces volatility and increases returns. As a strategy, however, it offers a valuable automatic pilot approach to constructive behavior in the face of adversity.