It’s an investor’s mantra: Rebalance your portfolio
regularly. But it may be worth rethinking that mantra.
The case for rebalancing is pretty straightforward. Over
time, assets whose prices rise account for a growing proportion of a
portfolio’s overall value, and those whose prices fall amount to a shrinking
share of the portfolio. Rebalancing, by selling securities that have risen in
value and buying assets whose value has declined, restores the investor’s
desired weighting of various assets within the portfolio.
“For some, it is an emotional anchor,” says Richard M.
Rosso, director of financial planning at wealth-management company RIA
Advisors.
Part of the logic behind rebalancing is that it maintains
the level of risk the investor is comfortable with, by ensuring that the
portfolio doesn’t skew too far beyond the desired balance between relatively
safe investments like highly rated bonds and riskier assets like stocks.
Rebalancing also is often seen by advisers and investors as
a formula for consistent returns, based on the idea that returns on different
asset classes tend to revert to historical norms: If stocks outperform their
historical average this year, then the chances are that future returns will be
lower, and vice versa. So, by this way of thinking, since stocks have
outperformed other assets recently, it would make sense to sell some and invest
the proceeds in assets that have performed less well. But this strategy has
holes.
While a strict rebalancing routine may help some investors
feel comfortable with their portfolio, that anchor may be holding them back,
Mr. Rosso says. “Rebalancing is sometimes counted as a way to get better
performance, but most methods don’t provide that,” he says. “I have yet to see
a study that shows that it improves your returns.”
Indeed, sometimes rebalancing can mean missing out on big
returns. In the 12 months through April 30, SPDR S&P 500 ETF (SPY), which
tracks the S&P 500 index, gained 48%, not including dividends. Investors
who rebalanced in the middle of that period by selling broad stockholdings gave
up substantial returns. And if they bought bonds in that rebalancing, they probably
didn’t make much on that investment. The iShares Broad USD Investment Grade
Corporate Bond ETF (USIG), which holds a basket of high-quality company bonds,
gained 2.9%, over the 12 months through April, excluding interest payments, and
slumped in the second half of that period.
Opposite of the traders’ adage
In fact, rebalancing goes directly against a maxim used by
many professional investors and traders: Cut your losers short and let your
winners run. That means if you own securities that are performing well, you
retain them., and you dump securities that have fallen behind or failed to
rally as expected.
Over the past year or so, the traders’ maxim has worked far
better than a regular rebalancing by asset class. Stimulus spending by the
federal government and the low-interest-rate policy of the Federal Reserve have
made relatively risky assets such as equities winners and left bonds with
little to offer in the way of returns. “Unless you count cryptocurrencies, the
only game in town is stocks,” Mr. Rosso says. “Your winners aren’t just
running, they are sprinting.”
But this is where risk comes back into play. Leaving too
much money invested in a frothy market can expose an investor to the
possibility of a catastrophic loss. That can make life tricky for advisers like
Mr. Rosso when they scale back a client’s holdings in a bull market. “I have to
help investors who are in a strong greed cycle,” he says. “They ask: Why did
you sell this?”
Buying out-of-favor assets
In the end, the argument against simple, routine rebalancing
is mostly that it isn’t nuanced enough—that adjusting a portfolio along the
lines of broad asset classes like stocks and bonds at set intervals might be
too blunt an instrument to improve performance. However, rebalancing by picking
out-of-favor sectors within those broad asset classes when opportunities
present themselves can be productive, says money manager Adam Johnson, author
of the Bullseye Brief financial newsletter.
“I’m generally a contrarian,” Mr. Johnson says. “If I were
to define rebalancing, I would allocate capital to where I can make the most
money, which means buying the stuff that other people hate.”
For instance, in 2018, Mr. Johnson was bullish on
semiconductor stocks, which were then out of favor and remained so until the
second quarter of 2019, when they began an epic rally. “They went nowhere until
they were hot,” he says. “I can’t tell you how depressing it was to buy semis
in 2018,” he says, but his patience paid off.
In managing an investor’s portfolio, Mr. Johnson
continuously rebalances based on predetermined price targets for individual
securities. “Let the market tell you when to rebalance,” he says.
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