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Rebalancing Portfolios

May 3, 2012

The theory of rebalancing explains that once an asset allocation for a portfolio is determined, the investments should be rebalanced periodically to remain in the agreed upon proportions.

 

I do not think this is a valid strategy in many situations.

 

Some think that rebalancing should take place at least once a year while others prefer doing it more frequently.  Let’s suppose that the rebalancing will be done once a year on December 31st.  In 2008 the stock market dropped 38% (as measured by the S&P 500 index). Further, in that year, Treasury Bonds increased in value (while yields dropped significantly). If the rebalancing was done based on the December 31 asset values the bond or fixed income portion of the portfolio would be a much higher proportion than it was a year earlier, and stocks a lot lower.. It was also a time of unprecedented change, loss of confidence, flight to asset security, stock market drop and the apparent beginning of a recession.  All of those factors are indicative of a weakness in the market.  Perhaps suggesting funds should be kept in more secure assets while the risk part of the portfolio is not to be added to.  However, the rebalancing would call for the exact opposite of this – adding to stocks and reducing secure higher interest bond positions. 

 

Further, rebalancing doesn’t just pertain to stocks versus bonds, but types of stocks and bonds within the portfolio.  For instance a portfolio of stocks that needs rebalancing would also need rebalancing between styles, sectors and countries.  Bonds would rebalance between U.S Treasury, corporate, municipal, foreign and high-yield bonds… at best an involved situation.

 

The purpose of rebalancing is to maintain the original proportions, but the original proportions were determined based on long-term objectives that should not be subject to fast, and possibly temporary or illusionary, swings in the market.  If the horizon is, say a ten year period, then the original allocation is constructed with the expectation of attaining those long-term objectives over that period.  The portfolio should be expected to undergo changes in the market values of its components, but also should be expected to behave in the predicted manner over the longer period.  Momentary or temporary swings that change the mix would be expected to self correct with back and forth swings so that the portfolio will eventually meet the pre-stated objectives. 

 

Another issue is when portfolios are rebalanced.  The total portfolio risk will change based on the original determination.  A swing into bonds from stocks would reduce the risk, while a swing to more stocks would increase risk.  Also, current portfolio yields and long term expected returns will also change, and possibly significantly with the large drop in yields with reinvested matured bonds and bank CD proceeds over the last three years.  Rebalancing is a risk management tool that needs to be utilized within the overall structure of goals, cash flow requirements and risk tolerance that presumably has been carefully considered when the asset allocation and portfolio mix was determined.

 

Rebalancing might also cause the sale of better performing securities and could result in current taxes and, in the case of bonds, selling higher yielding issues.

 

If you act perfunctory or don’t follow the original plan aren’t you saying that your original plan was either meaningless or flawed?  It also seems that active and frequent rebalancing make you a market timer – an ineffective strategy.

 

I suggest using unneeded dividends, interest and matured bonds to strategically rebalance by using them to add to the underweighted portion of your portfolio.

 

Rebalancing is a common strategy, but like most common things, might not be worth too much.  Know what you are planning, and why.  Do not quickly abandon your long-term paths.

One Comment leave one →
  1. morty permalink
    January 24, 2016 5:57 pm

    Thanks ed. Your comments were my sentiments

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