The Vital Role of Rebalancing

January 4, 2024

If there is a universal investment ideal, it is that every investor wants to buy low and sell high. What if we told you there is a disciplined process for doing just that, and staying on track towards your personal goals while you are at it? Well, guess what? There is. It is called rebalancing.

Rebalancing: How It Works

Imagine it is the first day of your investment experience. As you create your new portfolio, it is best if you do so according to a personalized plan that prescribes how much weight you want to give to each asset class. So much to stocks, so much to bonds, and so on. Assigning these weights is called asset allocation.

Then time passes. As the markets shift around, your investments stray from their original allocations. That means you are no longer invested according to plan, even if you have done nothing at all. You are now taking on higher or lower market risks and expected rewards than you originally intended. Unless your plans have changed, your portfolio needs some attention.

This is when rebalancing is used to shift your assets back to their intended, long-term allocations.

A Rebalancing Illustration

To illustrate, imagine you (or your advisor) has planned for your portfolio to be exposed to the stock and bond markets in a 50/50 mix. If stocks outperform bonds, you end up with too many stocks relative to bonds, until you are no longer at your intended, balanced blend. To rebalance your portfolio, you can sell some of the now-overweight stocks, and use the proceeds to buy bonds that have become underrepresented, until you are back at or near your desired mix. Another strategy is to use any new money you are adding to your portfolio anyway, to buy more of whatever is underweight at the time.

Either way, did you catch what just happened? Not only are you keeping your portfolio on track toward your goals, but you are buying low (underweight holdings) and selling high (overweight holdings). Better yet, the trades are not a matter of random guesswork or emotional reactions. The feat is accomplished according to your carefully crafted and fully customized plan.

Portfolio Balancing: A Closer Look

We have now shared a simple rebalancing illustration. In reality, rebalancing is more complicated, because asset allocation is completed on several levels. First, we suggest balancing your stocks versus bonds, reflecting your need to take on market risk in exchange for expected returns. Then we typically divide these assets among stock and bond subcategories, again according to your unique financial goals. For example, you can assign percentages of your stocks to small vs. large company and value vs. growth firms, and further divide these among international, U.S. and/or emerging markets.

One reason for these relatively precise allocations is to maximize your exposure to the right amount of expected market premiums for your personal goals, while minimizing the market risks involved by diversifying those risks around the globe and across sources of returns that do not always move in tandem with one another. We, and the fund managers we typically turn to for building our portfolios, are guided by these tenets of evidence-based investing.

Striking a Rebalancing Balance

Rebalancing using evidence-based investment strategies is integral to helping you succeed as an investor. But like any power tool, it should be used with care and understanding.

It is scary to do in real time. Everyone understands the logic of buying low and selling high. But when it is time to rebalance, your emotions make it easier said than done. To illustrate, consider these real-life scenarios.

When markets are down. Bad times in the market can represent good times for rebalancing. But that means you must sell some of your assets that have been doing okay and buy the unpopular ones. The Great Recession of 2007–2009 is a good example. To rebalance then, you had to sell some of your safe-harbor holdings and buy stocks, even as popular opinion was screaming that stocks were dead. Of course, history has shown otherwise. Those who did rebalance were best positioned to capture available returns during the subsequent recovery. But at the time, it represented a huge leap of faith in the academic evidence indicating that our capital markets would probably prevail.
When markets are up. An exuberant market can be another rebalancing opportunity, and another challenge, as you must sell some of your high flyers (selling high) and rebalance into the lonesome losers (buying low). At the time, this can feel counterintuitive. But disciplined rebalancing offers a rational approach to securing some of your past gains, managing your future risk exposure, and remaining invested as planned, for capturing future expected gains over the long-run.

Costs must be considered. Besides combatting your emotions, there are practical concerns. If trading were free, you could rebalance your portfolio daily with precision. In reality, trading incurs fees and potential tax liabilities. To achieve a reasonable middle ground, it is best to have guidelines for when and how to cost-effectively rebalance. If you would like to know more, we are happy to discuss the guidelines we employ for our own rebalancing strategies.

The Rebalancing Take-Home

Rebalancing using evidence-based investment strategies makes a great deal of sense once you understand the basics. It offers objective guidelines and a clear process to help you remain on course toward your personal goals in rocky markets. It ensures you are buying low and selling high along the way. What is not to like about that?

At the same time, rebalancing your globally diversified portfolio requires informed management, to ensure it is being integrated consistently and cost effectively. An objective advisor also can help prevent your emotions from interfering with your reason as you implement a rebalancing plan. Helping clients periodically employ efficient portfolio rebalancing is another way our team here at Shore Point Advisors seeks to add value to the investment experience.

This post was written and first distributed by Wendy J. Cook.

DISCLAIMERS

This material is intended for general public use. By providing this material, we are not undertaking to provide investment advice for any specific individual or situation, or to otherwise act in a fiduciary capacity. Please contact one of our financial professionals for guidance and information specific to your individual situation. This is not an offer to buy or sell a security.

Shore Point Advisors is an investment adviser located in Brielle, New Jersey. Shore Point Advisors is registered with the Securities and Exchange Commission (SEC). Registration of an investment adviser does not imply any specific level of skill or training and does not constitute an endorsement of the firm by the Commission. Shore Point Advisors only transacts business in states in which it is properly registered or is excluded or exempted from registration. Insurance products and services are offered through JCL Financial, LLC (“JCL”). Shore Point Advisors and JCL are affiliated entities.