We try to maintain a balanced life, eat a balanced diet, and, of course, we need balance to ride a bike. Balance is harmony. Investors should pursue balance; unfortunately, they rarely rebalance their portfolios, and they get too aggressive or too conservative at the wrong time.
Rebalancing is an excellent way to maintain your asset allocation and keep your risk tolerance in check, but what does it mean, and how does it work? When you rebalance your portfolio, you’re selling assets that have risen and buying ones that have declined – buy low and sell high. Rebalancing is done on a calendar basis – monthly, quarterly, or annually. Another option is to rebalance on a percentage basis. If an asset class rises or falls by 5% or more, you can adjust your portfolio by rebalancing. You can decide which model works best for your situation. Our firm rebalances based on the percentage moves of the asset classes in our models.
Let us look at a few moments in history to highlight this point.
If your portfolio consisted of 50% stocks and 50% bonds in 1929, your equity allocation dropped to 23%, and your bond allocation increased to 77% at the end of 1932, a mix too conservative based on your original allocation. If you rebalanced every year, you would have sold bonds to buy stocks. However, this would not have been so easy during the Great Depression. The Dow Jones Industrial Average fell 65% in four years, so it would have taken a bold investor with a firm conviction to buy stocks. Without rebalancing, you had to wait until 1955 before your allocation returned to 50% stocks and 50% bonds.
Stocks fell 43% during The Tech Wreck. If you started the decade with a 50% stock and 50% bond portfolio, it fell to 30% stocks and 70% bonds by the end of 2002. Twenty years later, your portfolio allocation is 40% stocks and 60% bonds. It has not yet returned to your original allocation because bonds have outperformed stocks for the past two decades. Bonds have generated an average annual return of 7.2%, while stocks have returned 5%.
If you were fortunate to start investing in 2009, your stock returns have done exceptionally well, averaging almost 11% per year. If you started with an allocation of 50% stocks and 50% bonds in 2009, your asset allocation entering 2020 was 73.5% stocks, and 26.5% bonds – too aggressive based on your initial target.
Stocks are off to a horrible start this year, and your original portfolio of 50% stocks and 50% bonds is now 45% stocks and 55% bonds after four months.
As you can see, balance is rarely maintained, and you must continuously monitor your accounts to make sure your portfolio stays balanced. If you do nothing, your portfolio can oscillate between too conservative or too aggressive – at the wrong time. For example, if you did not rebalance your accounts for the past ten years, your equity risk was too high at its peak in February, before the S&P 500 fell 34% in March. If you did not rebalance your accounts in 2008, your portfolio was too conservative to benefit from the rebound in stocks starting in 2009.
Here are a few tips to help you rebalance your portfolio.
- Rebalancing your accounts annually is recommended, but you can also do it monthly or quarterly. Due to the increased volatility in stocks recently, we are running our rebalancing models weekly.
- January is an excellent month to rebalance your accounts because most mutual funds pay dividends and capital gains in December.
- Your 401(k) plan may have an automatic rebalancing tab allowing you to set it and forget it. Your plan should give you the option to rebalance monthly, quarterly, or annually.
- It’s easier to rebalance a portfolio of mutual funds or ETFs than it is a basket of individual stocks or bonds. It’s not possible to sell a half share of a stock or a third of a bond. If you plan to rebalance your accounts, stick with funds.
- If possible, automate the process of rebalancing. It’s emotionally challenging to sell stocks when they’re rising, harder to buy them when they’re falling. Automating this process will remove your emotions from the buy and sell decisions.
Rebalancing may or may not increase your returns, but it will allow you to preserve your asset allocation and risk tolerance. If you invested $20,000 in 1992 in Vanguard’s Total Stock Fund (VTSMX) and Vanguard’s Total Bond Fund (VBTIX) – 50% allocation to each, your ending balance as of March 31, 2020, was $152,903. Your investment produced an average annual return of 7.5% without rebalancing. Your allocation, 28 years later, is 70% stocks, 30% bonds. If you rebalanced your account annually to an allocation of 50% stocks and 50% bonds, your return improved to 7.7% and your balance is now $160,156. In this case, your allocation and risk level stayed constant, and your performance improved, which is the goal of rebalancing.
The key to long term financial success is to match your financial goals to your investment portfolio. A financial plan will help you identify your hopes, dreams, and fears. Once you complete this process, put your plan to work and rebalance your accounts often!
Life is like riding a bicycle. To keep your balance, you must keep moving. ~ Albert Einstein
April 16, 2020
Bill Parrott, CFP®, is the President and CEO of Parrott Wealth Management located in Austin, Texas. Parrott Wealth Management is a fee-only, fiduciary, registered investment advisor firm. Our goal is to remove complexity, confusion, and worry from the investment and financial planning process so our clients can pursue a life of purpose. Our firm does not have an asset or fee minimum, and we work with anybody who needs financial help regardless of age, income, or asset level. PWM’s custodian is TD Ameritrade, and our annual fee starts at .5% of your assets and drops depending on the level of your assets.
Note: Investments are not guaranteed and do involve risk. Your returns may differ from those posted in this blog. PWM is not a tax advisor, nor do we give tax advice. Please consult your tax advisor for items that are specific to your situation. Options involve risk and aren’t suitable for every investor.
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