What you need to know about rebalancing methods, timing, and the impacts of volatility
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You know that your portfolio should be diversified—well-rounded, considerate of proper risk, and open to new opportunities. But rebalancing your portfolio can be easily overlooked, especially if you have a buy and hold portfolio. While some asset classes can sit tight, such as your real estate or other illiquid investments, your stocks and bonds can greatly benefit from some strategic rebalancing.
Why exactly should you rebalance? Rebalancing is key when assets in your portfolio stray from their strategic target. Reallocating funds from overweight assets to underweight assets ensures your portfolio hits the mark—as opposed to becoming one-sided or reliant on the performance of one or two assets.
There are several ways you can rebalance your portfolio. It all depends on what suits your taste and emotions when it comes to shifting your investments.
We’re going to look at what the research suggests regarding rebalancing strategies, and the practical steps you can take to ensure your portfolio is pulling strong for the long run.
Positive Skewness and Faulty Emotions
A buy-and-hold portfolio with stocks and bonds will eventually become entirely stock-based because stocks are the higher-performing asset. Rebalancing allows you to shift your investments periodically to make sure your portfolio as a whole is hitting the target mark in terms of how much risk you are willing to take.
We’re going to focus on why this is so important regarding stocks.
Stocks are more volatile than other assets. Volatility measures how much an asset’s price or return rises or falls over time. The more ups and downs an asset exhibits, the greater its volatility. Volatility in a portfolio means there is also positive skewness.
Now, skewness is a statistical term. Skewness occurs when the median or middle outcome is less than the expected outcome.
For example, most people in the world have much less wealth than average because a relatively small number of billionaires bring up the average. If we rank the entire population in the U.S. by wealth, the middle or median person will have less wealth than the overall average.
Investing works the same way. We don’t know how much wealth we will have when we retire. That depends on how much we save and on market returns. As we pass through time, if we take more risk by increasing our portfolio’s volatility, there will be some wealth outcomes where we do incredibly well, bringing up the average, while most outcomes fall below the average. There will also be some outcomes where we end up much poorer than we would have liked.
If we think of it in terms of a normal bell curve, there are nice, even distributions on either side of the curve. But wealth outcomes, how much money we have at the end of the day, is not normally distributed.
Positive skewness causes more of the observed outcomes to fall to the left of the curve (underperformance)—with a fat tail to the right of the curve demonstrating the few (but powerful) observations that exceeded the expectation. The natural bell curve of the observations becomes skewed when there are these outlying performances that cause the middle (median) observation to fall short of the expected outcome.
Why is this important?
As an investor, you need to know if a return distribution is skewed, rather than simply taking note of the average return. Unless you’re a long-term investor, you likely won’t be able to recoup the cost of a sharp fall from the target.
You’ll run the risk of your portfolio falling below your expectations and not hitting the mark. You may hit a homerun and see your portfolio outperform—but that’s rarely the case.
Interestingly, studies have shown that investors are actually drawn to skewed investments.
Why?
Well, think about all the times you’ve heard of an amazing investment opportunity. You hear the stories where someone hit it big, and you want to jump on the bandwagon too.
Even if you’re not someone to follow fads or chase the new, you can fall into the trap of narrow framing. This is where investors consider an investment without looking at the needs of their portfolio as a whole. It’s a new opportunity, and if it’s positively skewed, there’s the potential big profits. So they decide to invest in it.
When our emotions are leading us towards one of these traps, we need to remember the goal of our portfolio as a whole. Is this new investment helping to compound our portfolio’s health? Or is it a risky, feel-good endeavor that may take years to recover from if it goes poorly?
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Don’t Let High Volatility Drag You Down
What impacts skewness? Volatility. The lower the volatility, the greater the likelihood the ending wealth from investing in an asset or portfolio will be close to the average expected outcome over a sustained period of time. The higher the volatility, the greater the chance the ending wealth from investing in an asset or a portfolio will fall below the expected outcome—or that it might be a huge win.
Volatility drag is created when a volatile asset falls below the expected return, significantly drawing out the time it takes for you to recoup and compound your initial investment. The more volatile your portfolio is as a whole, the more risk you run of volatility drag.
For example, if you lose 50.0% of your portfolio due to it being positively skewed, it’s going to take a 100% return to make up the original cost. This is because, after such a substantial loss, you have half as much money in the market working for you; earning interest and generating capital gains. That remaining capital has to return twice as much on a return basis to make up for the percentage loss.
How do you avoid volatility drag?
Rebalancing allows you to keep your risk tolerance within your boundaries. It ensures you don’t become too concentrated in any specific asset. Diversification and rebalancing work together to guide your portfolio towards the expected goal.
Volatility can’t be entirely avoided. We can only manage risk, not eliminate it. But since we only have one shot with our portfolio, we need to maintain it the best we can. Rebalancing is a key part of that.
When Rebalancing Becomes Imbalanced
Even though rebalancing has consistently been shown to reduce volatility drag, it sometimes leads to unwanted outcomes.
When looking at the long term, rebalancing is the right move—without a doubt. But if you decide to reallocate funds by selling one investment and purchasing another, then you run the risk of that original investment doing really well after you sell it, or the underweight asset you allocated more money to continues to do poorly.
Rebalancing relies on the assets in your portfolio reverting back to their average return rate. Sometimes it can be a while before that happens, and we have to be patient enough to see the follow-through.
Remember, rebalancing is about creating a healthy portfolio for the long term. Short and intermediate losses and gains will occur, but the goal is to maintain a portfolio that will increase your wealth in the long run.
When rebalancing, it is important to account for the costs associated with moving around investments. There’s capital gains tax and potentially commissions or other fees.
If calculating the cost of rebalancing is intimidating to you, consider using the spreadsheet calculator offered to Money For the Rest of Us Plus members. It can help you decipher which investments to reallocate and what you need to recoup in order to balance out the possible tax hits and commission fees.
Timing Isn’t Everything
When should you rebalance your portfolio? Thankfully, the answer is pretty simple. Whenever suits you best.
There have been multiple studies examining various portfolios that are rebalanced at different intervals, under different parameters, and with differently weighted assets.
One study by Rattray, et al. demonstrated that with a US portfolio compiled of 60.0% stocks and 40.0% bonds within a date range of 57 years, that it didn’t matter whether it was rebalanced monthly, quarterly, or annually. Or whether it was rebalanced based upon differing thresholds (two percentage points away from the target or four percentage points away).
There was also no significant difference in outcome regarding rebalancing fully back to target, rebalancing halfway, or even a quarter of the way. They even considered the consequences of rebalancing based upon trends, including 12-month and 3-month trends. The difference in outcome was still less than 1.0%.
Another study by Hong and Meyer-Brauns looked at a similar portfolio over a 40-year interval. They looked at the effects of annual rebalancing and basing rebalancing on risk tolerances. The returns were still so close together in comparison that it again demonstrated it really doesn’t matter which method is used.
So there are several ways you can go about rebalancing your portfolio:
- By time interval: You schedule your rebalancing to occur monthly, quarterly, annually, etc.
- By threshold or risk tolerance band: You decide the percentage point range around the target for each asset class(i.e. five or ten percentage points away from the target) and rebalance when that threshold is breached.
Basically, there’s no one right answer when it comes to when and how to rebalance.
Rebalance Your Portfolio the Way That’s Best for You
At the end of the day, what is the goal of rebalancing?
It’s to decrease risk, help diversify your portfolio, avoid volatility drag, and reduce over-concentration. It’s to create and maintain a healthy portfolio that will compound your wealth in the long run.
Avoiding maximum drawdown risk is essential. You only have one shot with your portfolio, and you can’t be wasting your time recouping large losses due to positive skewness.
It can be comforting to know that there’s no one way of rebalancing. Whatever method you choose, it’s been shown to be effective. Don’t let your emotions get in the way. This is not something to fret over. If you find yourself stressed about rebalancing, choose one method and stick to it. Sometimes having a rule-of-thumb can keep our emotions in check and keep you moving forward.
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Emily Boulter is a professional writer with a B.A. in English & Writing from Regent University. With experience in show notes writing, grant writing, and business writing, she has a deep passion for helping others through her writing and non-profit initiatives. Emily lives in the Rocky Mountains of Colorado and can easily be found hiking, horseback riding, or reading in one of the local coffee shops.
David Stein is the founder of Money for the Rest of Us. Since 2014, he has produced and hosted the Money for the Rest of Us investing podcast. The podcast reaches tens of thousands of listeners per episode and has been nominated for ten Plutus Awards and won one. David also leads Money for the Rest of Us Plus, a premium investment education platform that provides professional-grade portfolio tools and training to over 1,000 individual investors. He is the author of Money for the Rest of Us: 10 Questions to Master Successful Investing, which was published by McGraw-Hill. Previously, David spent over a decade as an institutional investment advisor and portfolio manager. He was a managing partner at FEG Investment Advisors, a $15 billion investment advisory firm. At FEG, David served as Chief Investment Strategist and Chief Portfolio Strategist.
356: How, When, and Why Should You Rebalance Your Investment Portfolio
Why bother rebalancing your investment portfolio and what is the best method for doing so.
Topics covered include:
- How a target asset allocation can get out of line if a portfolio is not rebalanced
- What is positive skewness and why it matters to portfolio investing
- What is volatility drag and how it can lead to lower end of period wealth
- What are the costs of rebalancing
- Which rebalancing method if any has been the most effective
Show Notes
Long-Horizon Stock Returns Are Positively Skewed by Adam Farago and Erik Hjalmarsson
Positively Skewed Distribution—Corporate Finance Institute
Prospect Theory and Stock Market Anomalies by Nicholas Barberis, Lawrence J. Jin, and Baolian Wang
Strategic Rebalancing by Sandy Rattray, Nicolas Granger, Campbell R. Harvey, and Otto Van Hemert
Portfolio Rebalancing: Tradeoffs and Decisions by Xing Hong and Philipp Meyer-Brauns
Safe Haven: Investing for Financial Storms by Mark Spitznagel
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Transcript
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