Our Thoughts

Rebalancing Principles

We’ve all heard it; buy low, sell high. It is the best way to make money in the markets. That is, if you can do it. The rebalancing discipline we use at FJY forces us to buy low and sell high, and by doing so, provides us the opportunity to benefit in two ways. By periodically rebalancing your portfolio we reduce the risk of your portfolio and increase the returns of your portfolio over the long run.

The markets in 2008 and 2009 provide us with a great opportunity to illustrate. We will use an example of a portfolio that is 50% bonds and 50% stocks. Realize of course that your portfolio is much more diverse and will have several types of investments in fixed income, a great variety of U.S. and Non-U.S. traditional equity, and may also have a fair amount of nontraditional investments like REITs, and/or managed futures. But, we like to keep things simple, so we will use a $1,000,000, 50/50 portfolio, and we will rebalance at the beginning of each year.

At the beginning of 2008, we invest $500,000 in bonds and $500,000 in stocks. At the end of 2008, our portfolio has declined about 20% because of the unprecedented movement in the equity markets. Our bonds are short/intermediate term and high quality, so they maintained their value. We still have $500,000 of bonds. However, because we invested in the S&P 500, our $500,000 of stocks is now only $300,000 reflecting a roughly 40% decline in the equity markets. This leaves the portfolio at $800,000 and a 20% loss. It also leaves the portfolio with 63% bonds ($500k/$800k) and 37% stocks.

It is now the beginning of 2009 and time to rebalance our portfolio. Because the target for bonds is 50% and we are disciplined investors, we sell $100,000 of bonds and with those proceeds, buy stocks. We now have $400,000 each of bonds and stocks. Our portfolio is rebalanced to 50/50.

2009 turns out to be a wonderful year for the stock portion of our portfolio with an increase of 25% in the S&P 500. The bond portion of our portfolio did well also, with an increase of about 5%. However, for this illustration, we will assume they had zero growth. Therefore, our bonds are still worth $400,000. The 25% increase in the stock portion of the portfolio is now $500,000. This leaves us with a $900,000 portfolio that is 44% bonds ($400k/$900k) and 56% stocks. At the beginning of 2010, we will rebalance again by trimming our stocks by $54,000 and adding the proceeds to bonds.

The two year total loss was $100,000, or 10%. Had we chosen not to rebalance at the beginning of 2009, our portfolio ending value would have been $875,000 and a loss of 12.5%. By rebalancing, we ended up with $25,000 more than had we not rebalanced – significantly more (25%).

The act of rebalancing forced us to buy low at the end of 2008 and forced us to sell after the great returns of 2009. The act of rebalancing will move gains from the volatility of stocks to the safety of bonds, thereby reducing the risk of the portfolio.

There are several questions to consider when rebalancing a portfolio. How far out of balance is the portfolio? Are there tax consequences to this rebalance? How often should we rebalance our portfolio? What is the cost of rebalancing (i.e., transaction fees)? Are we adding cash to the portfolio? Will we need cash from the portfolio?

There are a few theories about the timing of portfolio rebalancing. Probably the most important ratio to consider is that of bonds to stocks. If bonds become a much smaller allocation than your target, your portfolio is assuming more risk and you should consider rebalancing. Some say if your target for bonds is 50% and it moves a certain percentage from that, then you should rebalance. For example, if bonds get to 45% or 40% then you should rebalance. Others say you should rebalance based upon a time period. As in our example, you could rebalance each year at the same time, no matter how far from target you are. Some say rebalancing more often, say every quarter, is the right move. Some say every 18 months is good enough. We know someone who had their portfolio rebalanced several times per week, and we know of an advisor who says every five or six years is beneficial. Either way, we know there are benefits of rebalancing a portfolio and we recommend you “just do it.”

Less important to the stability of the portfolio is the rebalancing of the sub-asset classes. A bond portion of the portfolio may have several types of bonds: munis, corporates, government, international, etc. These all provide stability and have a greater impact on the portfolio risk. However, different types of bonds perform differently over time and benefits are achieved by rebalancing them to their targets. The same is true for each of the sub-asset classes of equity: small, large, growth, value, etc. In fact, because of the volatility of equity and alternative asset classes, more potential gain will be realized from periodic rebalancing in this part of the portfolio.

To reduce the cost of rebalancing, besides the obvious (rebalancing less often), FJY can coincide your rebalancing efforts to that of either adding to or taking from the portfolio.