It seems like at the beginning of each year, market pundits predict that equity markets will generate positive returns in the year ahead, with the majority of the predictions landing between 0% and 10%. Ironically, the broad U.S. equity market has finished outside of that range in 77 of the past 90 years, with annual returns ranging from +54% to -43%.
Considering the wide range of annual returns associated with stocks, it’s understandable that investors would look for strategies to limit their risk while potentially enhancing their long-term returns. One important tool in the investor’s arsenal that can help them with both of these goals is a systematic rebalancing plan.
What is Rebalancing?
In its simplest form, rebalancing is the process of selling assets that have performed well and buying those that haven’t performed as well (i.e., buying low and selling high). For the individual investor, that is often easier said than done, as this typically involves acting counter to the prevailing market sentiment.
Imagine retiring in 2007, just before the equity markets sold off sharply in 2008-09. Without a commitment to rebalancing and/or a trusted advisor providing guidance, investors were at risk of not only abandoning stocks altogether, but also of holding too little in equities. Had they deviated from their long-term target allocation in equities, they would have severely diminished the amount of wealth created by one of the strongest market rallies of our lifetime from March 2009 to early 2016, as the market rose over 220% during this period.
Rebalancing Helps Preserve Your Ideal Asset Allocation
The obvious question is how do we combat the urge to alter our original plan in times of turbulence? The answer is that you don’t make decisions at that juncture! You follow your pre-determined course of action, which was developed well before arriving at the point where decisions need to actually be made. The father of value investing, Benjamin Graham, once said, “Investment is most intelligent when it is most businesslike.” In other words, Mr. Graham was advocating that investors need to contain their emotions and rely on facts when making judgments. This is exactly the mindset needed when an investor rebalances their portfolio during times of market turbulence.
It should be noted that most professional investors view rebalancing as a way to enhance returns, but perhaps even more importantly, it is a great tool to manage risk. Selling riskier assets—stocks, commodities, private equity— when they’ve performed well to buy more stable assets—bonds, cash— or vice versa, resets the risk/return profile of your portfolio back to the original target. It is my belief that once you design and implement a portfolio to match your long-term investment goals and risk tolerance, you should preserve its structural integrity. And the best way to preserve your ideal asset allocation is to rebalance regularly, even when markets are volatile.
Rebalancing a portfolio may cause investors to incur tax liabilities and/or transaction costs and does not assure a profit or protect against a loss.