Just as trees need to be trimmed and every garden has to be weeded, informed investors know they must prune every portfolio periodically to help it grow better.
In fact, some active managers have even found that periodic rebalancing generates additional returns that add to portfolio outperformance.
The process of examining a portfolio and cutting it back to its original asset allocation strategy and risk level is called "portfolio rebalancing." It's an essential part of maintaining any long-term investment strategy needed to buy a house or to retire.
In this article, you'll learn how to protect your investments and improve your return by rebalancing your portfolio; but first, it's important to understand why the need even arises.
Why You Should Rebalance Your Portfolio
Why should you rebalance your portfolio?
In the real world, some investors let their emotions encourage them to buy and sell investments at the wrong time. Too often, studies have shown that investors buy high and sell low so that they end up spending more money than a stock is worth when the market is rising and losing more money when a stock is in freefall.
Making emotional and irrational buy and sell decisions is just one factor, but there are others:
- The dynamics of the stock market
- Fund drift - changes in the mutual funds that comprise your portfolio
Portfolio rebalancing helps ensure that your portfolio doesn't grow out of control and become riskier than you intended. Failure to do this can hurt your future results.
No matter what strategy is used, investors should perform portfolio rebalancing regularly. While the need for rebalancing is easy to understand, it is not a simple task.
What Happens During Rebalancing
When rebalancing happens, it changes the outcomes of individual portfolio components.
As one manager described, "Rebalancing prevents winning investments from earning higher weights and losers from decaying to lower weights. In other words, a rebalanced portfolio forgoes the very best buy-and-hold outcomes…, where winning investments keep on winning and compounding their gains and, losers fizzle out to small, inconsequential weights."
Also, any rebalancing strategy can reduce risk - and increase the return on investments - as opposed to following a buy-and-hold strategy.
When an investor uses a buy-and-hold strategy, it often increases the risk concentration among winning investments. For this reason, some managers rebalance portfolios using a risk-targeting component as part of their overall asset allocation process.
In a risk-targeting strategy, portfolios sell investments when they become more volatile. A helpful tool to make this determination (about whether a portfolio's higher returns are due to taking on added risk or investment selection) is the Sharpe Ratio. Do-it-yourself investors can evaluate their portfolio using this online Sharpe ratio tool.
Robo advisors can also rebalance portfolios for you. Some of the features included in Robo advisor rebalancing services address tax, stock substitutions, and asset-class customization.
Common Mistakes Investors Make When Rebalancing
While it's easy to recognize the need to rebalance, investors often make mistakes that result in portfolio losses while also eroding long-term wealth-accumulation. Behavioral finance experts have identified many of these mistakes.
Among the most common mistakes that prevent investors from rebalancing are:
- Herd mentality
Following the herd happens when people follow the crowd and pile on to buy or sell the most fashionable stocks.
- Regret aversion
Regret aversion causes investors to hold losing positions too long or the opposite, staying out of a market so that they miss investment bargains.
- Mental accounting
Mental accounting happens when people don't recognize their investments' interrelationships to their overall portfolio and risk tolerance levels.
For instance, investors may only see the recent performance of one dedicated investment to pay for college, but not the performance of their other investments related to long-term retirement.
Often, investors will accept losses in one set of investments as long as another shows a better return. When this happens, investors fail to recognize they should rebalance in order to optimize each investment category for the best risk-adjusted return.
How a Dynamic Stock Market Increases Risk Levels
Markets are dynamic, so all of its parts are always moving. This includes stock prices, the business and financial activities of listed companies, entire market segments, the overall economy, and monetary policy. All of these elements expand and contract over any time horizon.
All these moving parts mean portfolios must be reconfigured to account for the extensive changes that happen over time.
The rebalancing process brings asset allocations and risk limits into line with the investor's original goals. If rebalancing does not occur, portfolios can become riskier, which exaggerates gains and losses.
Risk management is essential because stocks are three times riskier (as measured by volatility) than bonds.
In periods of volatility, a 50/50 portfolio means you have 90% of the risk in stocks. A random analysis of any time period will show the returns of the S&P 500 Index versus Barclays Aggregate Bond Index performance, for example, will show that equity losses will disproportionately drag down the traditionally structured 60% stock-40% bond or 50% stock -50% bond portfolio in bear markets. This is due to the risk performance of equities. Conversely, in bull markets, the equity risk profile will buoy returns.
Accounting for Fund Drift
Another reason why portfolios need rebalancing is due to "drift." Market drift works against you when your fund gets too big and too successful. While that may not sound like a problem, it can be expensive since it alters your diversification strategy.
Drift happens when mutual funds stray from their stated investing mandate over time. For instance, growth funds start to buy value stocks, or large-cap funds start to hold cash or begin investing in small-cap NASDAQ companies.
So, when a portfolio manager starts to move their fund into a new direction, it can take your well-planned diversification strategy on an unanticipated path.
While this could be considered an adventure, it makes for bad investing. Drift means you have no control over the process.
How can you prevent your portfolio's diversification plans from going astray?
Why Overlap Occurs
Since investing is a social activity, fund managers often follow the same thought processes, share the same research, and get caught in national moods, which can focus their attention on a limited number of stocks. This is human.
Another complicating factor is that huge multi-national conglomerates often defy simple descriptions because they are involved in many different areas.
While this may be appealing to many fund managers, it poses problems for investors who are selecting companies to fill a specific niche in their portfolio. For example, a company like Microsoft or Google could be a top holding in technology, internet, large-cap, wireless, or a global mutual fund.
Then, there is the problem that happens when companies grow.
By definition, some small-cap managers should sell small-cap stocks when the company exceeds its capitalization ceiling. But as these companies increase in value, many managers do not sell because they have owned these stocks for years and don't want to part with a profit-making position.
This could make sense if the stock continues to increase in value, but it also violates the mutual fund's stated investment purpose as contained in its prospectus. It seems breaking up is hard to do for couples, as well as investment managers.
How to Check for Overlap
So how should an investor determine whether their diversification plans are reflected in their holdings?
The best way to check for overlap is to find the top 10 holdings in your mutual funds and compare them against each other. You can find those holdings in the mutual fund's quarterly reports. However, that is a time-consuming process.
How do you differentiate drift?
This is very difficult for an individual since it's hard to determine what constitutes a small-, mid- or large-cap stock. Individuals also cannot differentiate between the price-earnings and price-to-book ratios used to classify value or growth stocks. There are some online tools for investors to determine the extent of the mutual fund overlap, but this is a good reason to consult with a financial advisor too.
Another alternative is to buy exchange-traded funds (ETFs). Due to their construction, ETFs rebalance back to their tracking index automatically. This makes it much easier to maintain an exposure to asset classes in an investment portfolio.
There are also mutual funds that rebalance automatically. These "all-in-one" mutual funds offered by Vanguard let you invest in portfolios containing thousands of stocks, and they do the rebalancing work for you at a very low cost.
Caveats Regarding Portfolio Rebalancing
While rebalancing seems straightforward, it does have some special situations.
One happens when an investor is exposed to emerging equity markets and during periods of economic crises, such as currency devaluations or central bank intervention. Investors also have to consider the transaction costs of rebalancing, the danger of pursuing market rallies, the new rebalanced portfolio's risk, and any problems associated with poor market timing.
While there is much to consider, the proven benefits of rebalancing demonstrate it's an essential element of the investing process. If you want help with rebalancing your portfolio, you can explore different financial advisor and Robo-advisor options below.