Your retired clients have a handle on their expenses and are spending according to plan. They are withdrawing at a rate that seems reasonable. The myriad of studies about safe withdrawal rates support this thinking. You have shared this information with clients and all is well.

Then the markets drop and the world seems focused on how far down the bottom may be. Everybody did the right things. The exposure to different asset classes aligned with their goals, they are diversified, and they controlled their spending. Yet, through no fault of theirs, the client's "safe" withdrawal rate seems less safe. They are disturbed. What will we all do?

This isn't a hypothetical. It is a brief description of something that just happened. So what did you do in the fall of 2008 and early 2009? Did you rebalance? I hope so. According to most of the studies on which you found comfort, you were supposed to rebalance at some point.

We did, but I can't say clients were thrilled about it at the time. In late February 2009, I got this question, "You are naïve to think we are not headed into the next Great Depression. I know that no one can predict what will happen, but since the market is going down, shouldn't we get out of its way?"

Classic. No one can predict, but it is going down (emphasis added). This person also sent me this quote from a March 5, 2009, Business Week article a couple of weeks later: "...could mean two more years of bouncing around and then another six or so before the Dow is back above 14,000. Not long ago, such an outcome would have seemed unimaginably bleak. Given the other possibilities, it doesn't seem so bad now."

To me, the quote was a bit puzzling. A quick calculation on a handheld calculator told me that with the Dow closing at 6594 on March 5 getting to 14,000 in eight years meant an annualized return of just under of 10%, excluding dividends. That's "unimaginably bleak"? The sentiment then was so bad, even a good result could seem awful.

Almost all of our clients stuck with their plans through the turmoil of '08/'09 and we rebalanced as we said we would. Those clients' portfolios recovered well, many reaching all-time highs even though the markets have yet to do so. A similar result came after the bear market that followed the bursting of the tech bubble.

I attribute some of our clients' ability to do what so few wished to do to our coaching and our behavior prior to the crisis. It is not a matter of if the market will experience a decline, it is a matter of what they will do when that happens so how we prepare them matters. Citing the behavior of U.S. markets, I often show clients that someone planning for 30 years of retirement should expect at least six bear markets averaging a decline of 30%. Every year, they should expect that at some point the market will drop at least 5%, and in half their remaining years, they should expect to see at least a 10% pull back. Further they should expect that - on average - five of their monthly statements each year will show losses on their equities.

To help them see the probable behavior of their portfolio, I apply these parameters to what proportion I think they should have in equities. I also discuss with them things they can consider changing to reduce the exposure to the drama of the equity markets.

I want clients to understand that uncertainty and change are inevitable and that what they will likely want to do during bad market environments is not what we will be looking to do. We will want to rebalance (buy), but they will probably want us to sell or hold tight "until things look better." We reinforce our messages about volatility and what should be done every chance we get. Rebalancing helps take some emotion out of decision-making. The reason so many of our clients allowed us to do what we said we would do was because doing so was not a surprise to them.

Most studies of portfolio sustainability make some sort of rebalancing assumption, most typically annually. Further, there are several studies that show a positive effect from rebalancing over time. Rebalancing usually either enhances returns, reduces volatility or it produces a combination of the two. Yet, when it should be done after a large change, many are hesitant. They fear being "early."

Rebalancing has a lot going for it. As soon as the per share price exceeds the price paid by enough, you will have a higher balance than you would if you hadn't bought because you own more shares from the buy. This also means one may recover faster.

Consider a portfolio that targets a 50/50 split between A and B with $100,000 in each. A earns 4% while B loses 20%. The total is $184,000 (A=$104,000 and B=$80,000). To rebalance, $12,000 is moved from A to B so each has $92,000. If A again rises 4%, it will be worth $95,680. The portfolio will be back to $200,000 when B rises 13.39% ($104,320-92000/92,000). If no rebalancing had occurred, A would be worth $108,160 and B would have had to add 14.80% to get the portfolio back to $200,000 (91,840-80,000/80,000).

At a rise of 13.39%, the actual price of B would still be off by 9.29%. This partially explains why so many of our clients were back to pre-Lehman levels long before the Dow or S&P 500. The lower the return on A, the higher the bounce required to make the portfolio whole. If A earned nothing, the bounce needed after a rebalance is 22.22% not the 25% required if no rebalancing had occurred.

Of course, if the market had dropped even lower, rebalancing would have added to the pain. This is what so many fear. Timing is everything as they say. Or is it?
 
In the scenario above, I did not make any indication of the time in between transactions. This could have occurred over a year, or over an hour and it has no bearing on the premise that buying when down, as you would if you rebalanced, can get the portfolio closer to whole faster than if no buy occurs. Despite this, most people have some anxiety about rebalancing after a big drop. The cause of this anxiety is another thing my scenario ignores -- what happens to prices in between the transactions.

Whether the rebalancing transaction occurs at the bottom, early or late makes no difference to the math above, it does present some psychological challenges. Few will want to "throw good money after bad" or "catch a falling knife" as pundits discuss "head fakes,"  "dead cat bounces," "sucker's rallies," short covering or similar things.

Being early may not be as bad as feared. For simplicity, assume A earns nothing but the low price of B ultimately ends up off 40% from its starting point. Rebalancing when we did (after a 20% decline) would result in a lower portfolio value than if no rebalancing occurred. How much lower? In this case, just $2,500 ($157,500 vs. $160,000).

The price of B actually has to drop by 25% from the rebalancing point to be able to say B has dropped a total of 40% from the starting point. The difference between rebalancing and not rebalancing is only the $10,000 buy after the 20% drop in B.

If you didn't rebalance at -20% but did at -40%, that would be a lot better, getting back to whole faster, right? The difference is smaller than many think. B would need to increase by 50% if the only rebalancing happened at -40%. If rebalancing had occurred at the -20% point and again at -40%, B would need to increase by 54%. Either rebalancing choice requires less of a bounce than the 66.67% required with no rebalancing at all.

Real life requires making decisions about an ongoing series of events. I've only isolated one sequence here and I am leaving out a great deal.  I'll have more next month. Until then, does whatever methodology you employ assume rebalancing? Do your clients know that and expect that? Will you be able to execute even in harsh conditions?

Dan Moisand, CFP, has been featured as one of the America's top independent financial advisors by most leading financial advisor publications. He has spoken to advisor groups on five continents on topics such as managing investments and navigating tax complexities for retirees, retirement readiness, and most topics relating to the development of the financial planning profession. He practices in Melbourne, Fla. You can reach him at [email protected].