Getting Your Head Wrapped Around Portfolio Rebalancing

A yoga master may tell you that aligning your “chakras” (the energy points or nodes in a “subtle body,” according to yogic tradition) on a regular basis will keep you healthy and happy. The same advice can apply to your portfolio strategy.

Portfolio rebalancing refers to the periodic shuffling of stocks, bonds, and other assets to maintain certain proportions (60% stocks/40% bonds, for example). It’s critical to your “core” financial strength in part because it helps reduce risks of overexposure to any particular position. It can also be a psychological challenge because it forces you to say goodbye to some of your star performers and welcome more of the lesser lights.

Here are a few things to consider.

Why rebalance?

When you first set up your portfolio allocation, you likely considered your age and life stage, your needs and those of your family, your risk tolerance, and other factors. Then you identified a mix of stocks, bonds, cash, and other investments that reflected you as an investor. As time goes by, asset values change. They grow (hopefully) or shrink, depending on what the markets do.

Eventually, a portfolio becomes “unbalanced,” that is, overallocated in one or more investments. For example, rising stock prices may push your equity allocation to 70%. That might appear welcome at first blush, but it leaves you susceptible to volatility spikes and bigger losses in certain assets.

Third eye blind?

You don’t need a third eye to see that market success comes from buying low and selling high. Theoretically, that’s what happens when you realign your portfolio because you’re taking from an asset that has grown and giving to an asset that hasn’t performed as well. But there are a couple things going on here. Let me enlighten you. 

First, if an asset has grown past your pre-determined allocation, it’s high, and the goal is to sell high. However, it’s difficult to tell whether it’ll continue to rise to a higher plain or if it has reached its peak. By rebalancing, you sell some of it at this “high” and then you may sell some more at the next “high.” 

Remember, you’re not liquidating your winners, you’re reducing them, so if the winner keeps growing, you’ll grow with it. While you may not grow as much, you still get growth while keeping within your risk target.

Second, reinvesting in lower-performing assets could result in further decreasing risk and capitalizing on new opportunities. For example, if you’re moving money from your stock allocation to your bond allocation, you’re reducing risk further because bonds aren’t usually as risky as stocks. Additionally, there are some years when bonds outperform stocks; by rebalancing, you could be better positioned to take advantage of those years. 

Third, if you’re reallocating from a top-performing stock or fund to a low-performer, then you may be reducing your exposure from a potentially overvalued asset to an undervalued asset that could be set to grow sometime in the future. In essence, you may be buying “low” or at least a reduced average cost per trade. 

Balancing yin and yang

Timing is important in a lot of things, which takes us to our next question: How often should you rebalance? Money managers traditionally rebalance every quarter or every year. But research from Gobind Daryanani published in the 2007 Journal of Financial Planning suggested a more opportunistic approach—not necessarily locking yourself to the calendar, but keeping a close eye on how asset classes fall into certain “bands.”

What’s that mean? For example, suppose a portfolio started at 50% stocks, 40% bonds, and 10% cash, but after a 20% increase in the value of the stocks, the portfolio shifted to 60%/35%/5%. That 20% “band” (the percentage shift from the original allocation level) would be a signal that the portfolio is overallocated in stocks and it’s time to rebalance. In terms of time intervals between rebalancing, Daryanani found that the best performance using the 20% band was 125 days. However, Jason Hsu of Research Affiliates found 11 months to work best for his large-cap stock portfolio. And Gregg S. Fisher found that rebalancing a portfolio each quarter helped him outperform his benchmark.

That’s not to say you need to be logging in to your account every 10 minutes, nor should you just set it and forget it. Be aware of your portfolio status and understand how real-world events can have an impact. Ultimately, the right rebalancing strategy boils down to what you’re comfortable with and what supports your longer-term goals.