Rebalancing: What is it? Why do you do it? How do you do it?

When I was a kid, I always wanted to have a perfect plate of food. To me, this meant an even amount of rice, meat and vegetables. So, if I ate a forkful of chicken, I would turn my plate to eat a similar quantity of rice, then vegetables. All the components would remain in even proportions until I was finished eating! Surely, all kids eat like this, right?

Just like my peculiar childhood eating habits, a core tenet of investing is the concept of rebalancing. Rebalancing is the process of bringing all components of your investment portfolio back to a targeted proportion. More specifically, as it relates to investments, this typically means selling a position that has become overweighted relative to its target allocation, and buying a position that has become underweighted. Typically, the reason a position has become overweighted is that it has experienced greater gains than the other positions in the portfolio. And conversely, the reason a position becomes underweighted is that it has either had losses, or simply smaller gains than other positions in the portfolio. What this means is that rebalancing is the process of selling whatever has recently done well, and buying whatever has done less well.

In a nutshell, rebalancing is the same as my childhood dinner plate. It’s the process of making sure all of the components are kept in their proper proportion.

At Navigoe, we approach each client’s portfolio as a household unit with target allocations to various asset classes and sub-classes. Asset classes are categories of investments, such as US Stocks, International Stocks, or Fixed Income. Sub-classes are categories within the asset classes. For example, US Large Value or US Small Cap are sub-classes within the broader US Stocks asset class. Depending on the size or complexity of a client’s portfolio, they will likely have between five to nine sub-classes in their portfolio.

What is Rebalancing?

As an example, let’s say you have a very simple portfolio that consists of 40% bonds, 30% US stocks, and 30% International stock. Over the next six months, both US and International stocks have a great run. You login to view your portfolio and find that your portfolio is now 25% bonds, 40% US stocks and 35% International stocks. This allocation no longer represents your targeted level of risk and safety for your goals. Due to the gains in the stock market, your portfolio has become higher risk.

In order to bring your portfolio back into alignment with your original allocation, you would sell 10% US stocks and 5% International stocks, and use the proceeds to buy bonds. After these trades, you would be back to the original 40% bonds, 30% US stocks, and 30% International stocks. What you have just done is rebalance your portfolio. Easy right? Well, yes and no.

Yes, it is easy in concept. Sell the overweighted asset classes, and buy the underweighted ones. The complexity creeps in when you consider the following questions:

• How often should I rebalance?

• Is it just about the stock to bond ratio? What about the various sub-class components?

• If stocks have been doing well, why would I want to sell?

• If stocks are crashing, is it really the right time to buy more stocks?

• What if I am retired and living off of my portfolio?

How often should I rebalance?

There are essentially two ways that you can approach rebalancing: the “calendar method” and the “percent out of balance method.” Keep in mind that while both methods have pros and cons, the most important consideration is your ability to maintain the discipline to continue to execute it methodically.

Calendar Method

The Calendar Method is the simpler, more straight-forward rebalancing method. As the name suggests, you designate a time based interval and rebalance at that time. Among those who use the calendar method, the most common intervals are quarterly, semi-annually, or annually. 

Percent Out of Balance Method

The Percent Out of Balance Method is generally considered the more effective strategy, but requires nearly daily monitoring of your portfolio to implement. Here’s how it works: after you have designated your portfolio target allocation, you determine the “tolerance range” which is the amount that any asset class or sub-class can move from its target allocation before it requires rebalancing. Research suggests that the optimal tolerance range is 20% above and below the target allocation.

For example, in the earlier portfolio the target for international stocks was 30%. A 20% tolerance range would allow your international stocks to rise as high as 36% or as low as 24% of your portfolio allocation before a rebalance is triggered. This is the method that we use at Navigoe.

Is it just about the stock to bond ratio? What about the various sub-class components?

At Navigoe, we analyze client portfolios for rebalancing on the following levels:

• Stock to bond ratio

• US to International stocks ratio

• Large stocks vs small stocks ratio

• Short term bonds to medium term bonds ratio

This means that the tolerance range test is applied at each of these asset class and sub-class levels. Additionally, during a market downturn, when we freeze the fixed income portion for retired clients (more on that below), we continue to keep the equity asset classes and sub-classes within their respective ratios.

If stocks have been doing well, why would I want to sell?

Investing in the stock market can be a bit of an emotional roller coaster. When stocks are going up, investors feel happy and optimistic. That optimism leads to a feeling that the good times are here to stay and markets are going to continue their upward climb. In fact, this might be true. By sticking to your rebalancing process, you might be selling some stock positions that have gone up, only to watch them go up further. However, even in the best of times, we know that stocks don’t just go up forever. Eventually, when a market downturn happens, your portfolio will be properly allocated with the appropriate amount of risk that you originally targeted. As an additional benefit, this discipline caused you to sell stocks when they were up, adding to your lower risk investments, like bonds.

If stocks are crashing, is it really the right time to buy more stocks?

When that roller coaster comes tumbling down from their peak, it’s usually accompanied with bad news. That news might be scary world events such as military conflict, natural disasters, or as we’re experiencing today, a pandemic. The world news is almost always accompanied by bad economic news such as rising unemployment, signs of a recession, or unstable trade or commodities prices.

In the midst of all this bad news and crashing markets, selling bonds and adding it to a stock market that appears to be in freefall will feel like insanity. It will feel like throwing good money after bad. It will feel like the scary world news and the tumbling markets have no end in sight. But, if you believe in the human spirit and the will of people all around the world to eventually go back to living their lives, the scary news and the declining markets will come to an end.

By maintaining the discipline to continue to rebalance in the midst of declining markets, you will be buying stocks at lower prices, which will reap benefits when the market eventually recovers. In fact, for those who are still many years from retirement, a main purpose of bonds in the portfolio is to take advantage of dips in the market.

What if I’m retired and living off of my portfolio?

Ah, this situation requires a different plan. At Navigoe, many of our clients are retired, and a monthly distribution from their portfolio provides an important part of the overall cash flow necessary for both basic living expenses and well earned luxuries. If you are one of these clients, our highest priority is to maintain your cash flow, even through the market downturn.

Our plan for retired clients is to maintain an adequate allocation in fixed income to provide several years of cash flow, ideally at least six year’s worth of cash flow. For example, if you have a $2 million portfolio with a 60% stock, 40% bond allocation, and you are taking an annual distribution of $100,000, you have eight years’ worth of cash flow in fixed income. 40% of $2 million is $800,000, which is eight times your annual cash flow.

The strategy for retired clients during a market downturn is to freeze the stock:bond rebalancing. Normally, in a market crash rebalancing rules would require selling bonds to buy stocks. However, for a retired client, this would reduce the number of years’ worth of cash flow that you have available in fixed income. By freezing the stock:bond rebalancing, the bond reserve is maintained.

Of course, this doesn’t mean that we simply stop rebalancing. Within the stock sub-classes, we make sure that your US:International stock allocation is kept in balance; likewise for your large cap vs small cap stocks.

The bottom line is that rebalancing is an effective way to manage your portfolio in a structured, disciplined manner. As you can see, there is not only one way to go about it. While each of the methods have pros and cons, the most important consideration is that you implement whatever method you select consistently.