by Dr. Robert N. Mayer, Professor, Family and Consumer Studies, University of Utah
Very few of us have the time, ability, or inclination to become investment experts, but we can do nicely by relying on a few simple rules: clarify your financial goals; start saving early and contribute regularly; diversify your investments within and across asset classes; and keep down costs. There is one rule, however, that people tend to ignore—rebalance your investment portfolio (when appropriate). Failing to following this rule can be costly and, perhaps worse, result in a lot of regret.
Rebalancing presumes that you have already followed the basic investing rule of constructing an investment portfolio that is consistent with your personal risk tolerance. Your investment portfolio is the array of assets (e.g., stocks in individual companies; corporate or government bonds; mutual funds and exchange-traded funds; real estate; precious metals; cash equivalents) you own. And your risk tolerance is your ability and inclination to take on a high or low degree of risk in your overall investment portfolio.
For example, a young investor is generally more able to take on more investment risk than an older investor because the young investor has far more time to recoup any short-term financial losses. Similarly, a person who enjoys skydiving and white water rafting may be more comfortable investing in emerging markets or new companies relative to someone who spends his/her spare time playing chess and puttering in the garden.
There is nothing intrinsically better or worse about being a high-risk or low-risk investor. That’s an individual matter. There is something wrong, however, in building an investment portfolio that is out of step with your risk tolerance. So, whether guided by a friendly financial planning professional, a so-called robo-advisor (typically an online wealth management service that uses computer-based rules to offer financial advice), or one’s own financial acumen, the investment portfolio should reflect risk tolerance. As time passes, it is the responsibility of the investor to “rebalance” the portfolio to make sure its mix of assets still reflects the a person’s underlying risk tolerance—and not allow the risk tolerance to change in response to the performance of different asset classes.
Rebalancing typically involves selling some of the assets that have gained the most in value and buying assets that have performed relatively less well. This sounds counterintuitive and helps explain why so many people have difficulty rebalancing their portfolios, but if you think about it, you are “selling high and buying low.”
While some experts contend that rebalancing improves long-term portfolio performance, the main benefit of rebalancing is to reduce volatility, risk and the impact of unpleasant surprises. Let’s imagine a forty-year-old inexperienced investor, Lance, who barely knows the difference between a stock and a bond, but witnessed the stock market soar in 2003 and the bond market go up as well that year. Lance decides to pull his $200,000 in savings out of a bank at the beginning of 2004 and invest 60 percent in a well-diversified stock mutual fund and the other 40 percent in a well-diversified bond mutual fund. This would be considered a conservative allocation for a forty-year-old investor, but Lance, despite his name, isn’t a big risk-taker.
During 2004, let’s suppose (and these number are very close to what actually happened) the stock portion of Lance’s portfolio went up by almost 11 percent while the bond portion rose by 4 percent. By the end of the year, Lance had $133,200 in stock and $83,200 in bonds. As a result of the different rates of increase, Lance now had 61.6 percent of his portfolio in stock and 38.4 percent in bond – not too far off from his target of 50 percent in each.
Now let’s let a few more years pass and assume that stocks continue to outperform bonds at about the same differential. By the end of 2007, the stock portion Lance’s portfolio would be $182,168, and the bond portion would be $93,589. Lance is feeling really good about the overall performance of his portfolio. It has grown from $200,000 to $275,757—or 37.9 percent— in the course of only four years. The stock portion of the portfolio has grown to 66 percent, but Lance doesn’t mind. Indeed, he regrets not putting a higher percentage in stocks at the beginning of 2004. So he sits tight and waits for continued growth in 2008.
Unfortunately, 2008 was a really lousy year for stocks, as they declined 37 percent. Bonds increased in value by 5 percent. At the end of 2008, Lance’s portfolio is worth $213,034—not bad considering that he just went through one of the worst stock market drops in U.S. history. The stock component of Lance’s portfolio is now worth only $114,766 (54 percent), while the bond component is worth $98,268 (46 percent).
What would have happened, though, if Lance hadn’t fallen in love with his rapidly rising stocks and remembered to rebalance his portfolio at the end of 2007, when his overall allocation exceeded a 5 percent deviation from his pre-determined 60-40 mix? At end of 2007, Lance would have sold approximately $17,000 in stocks and purchased $17,000 in bonds. The renewed 60-40 split would have meant that he had $165,454 in stock and $110,303 in bonds.
Where does Lance stand now after the awful stock market performance of 2008? His stock losses are on a smaller base than before, and his bond gains are on a larger base. Instead of seeing the value of his stocks drop by about $67,000, they dropped by about $61,000. Moreover, the overall balance in his account is $220,054—a $7,000 improvement relative to the portfolio with rebalancing. Seven thousand dollars may not seem like a large amount, but remember all that it took to “earn” it was one instance of rebalancing. The difference between the un-rebalanced and rebalanced accounts would, of course, be more dramatic if the original allocation had 70-30 or 80-20 between stocks and bonds. Or suppose that Lance, instead of being forty years old, is a recent retiree who has $2 million in his retirement account at the beginning of 2004 rather than $200,000. Then rebalancing would have done far more to cushion the blow of the stock market swoon.
How often should an investor rebalance his or her portfolio? There is no right answer, but one rule of thumb is to rebalance once one of your major asset classes has changed by five percent or more from your original allocation. Other experts recommend rebalancing every 12 or 15 months. Some investment accounts can be set to rebalance automatically at a given time interval or a specified change in the value of an asset. It doesn’t make sense, though, to rebalance after small changes because there can be transaction expenses associated with buying and selling assets. The main lesson is not to be your own worst enemy by assuming that just because an asset has gone up substantially in value that it has earned a larger portion of your investment portfolio. If you set your initial asset allocation based on a careful examination of your risk tolerance