In my column last month, I continued a discussion about rebalancing.  Studies show that for most lengthy time periods, several forms of rebalancing disciplines added to return or reduced return variability compared to a never rebalanced mix.

Rebalancing can encourage a buy-low, sell-high behavior. It helps maintain exposure to risk factors needed over the long term. It does not require accurate market forecasts to be beneficial and a rebalancing discipline can help address some of the emotional aspects of managing a portfolio. Properly educated about the matter, clients may be less inclined to get swept up in times of hype or dragged down in times of despair. Rebalancing can give clients a sense of control they crave in chaotic times.

Every study about the sustainability of withdrawals from a portfolio has some rebalancing assumption imbedded within it. I focused on the importance of buying when markets are down and showed fears of making things worse by being "early" when one rebalances may be overblown.    
The basic scenario consisted of a portfolio with a 50/50 split between A and B.  B dropped significantly.  We rebalanced, buying more of B to bring the mix back to 50/50 and the portfolio got back to whole before B's price had fully recovered even when our rebalancing missed the bottom.  There were neither indications of the time in between transactions nor any indication of what exactly A and B were.  The timing and the identities of the components are both irrelevant to the mathematics.

However, just as the ingredients in a dish affect its taste, what the components of a portfolio are exactly can be critical.  

The first issue to consider about A and B is that in order for the favorable math to manifest itself, A and B must behave differently. If A had declined to a similar degree as B, the amount sold out of one asset class to purchase the other would have been minimal. When B rose, the appreciation of the newly purchased shares would have little effect.

If A had actually declined more than B, rebalancing would have resulted in selling B to purchase shares of A thus reducing any benefit of a rebound in shares of B. Of course, if A and B had the same decline. no rebalancing would have occurred.

2008 reminded us that in tumultuous markets, correlations between equity asset classes often go up. We saw small, large, foreign, domestic, emerging, growth, and value all decline precipitously during the crisis. Having some portion of a portfolio in bonds and cash as "dry powder" provided those with the discipline to rebalance the means with which to do so.  

Not all portfolios with bond holdings were able to take advantage of the rebalancing opportunity. Today's interest rates distort our memories. During the summer of 2008 interest rates were considered low and many investors were stretching for yield. Those that obtained yield by compromising on the credit quality of the bonds and bond funds they owned experienced some nasty surprises as the credit markets froze up. Losses for 2008 of 30% or more were plentiful in high-yield bond funds. Even some short duration funds experienced significant losses.

Today, with rates low, I see many increasing their risk in the quest for yield.  Compromising on credit quality, buying longer-term fixed instruments, and buying dividend-paying stocks are all common reactions.  Readers of this publication should see that all three of these options could result in losses that could impede the effectiveness of rebalancing.    

One rebalancing related lesson from 2008 is that while low correlation is desirable, correlation should not be the primary consideration when selecting assets for a portfolio. Correlations are not particularly stable.  For instance, purveyors of many alternative investments often tout low correlation in their marketing. We saw in 2008 many of the same vehicles collapse in price.

Even among those alternatives that held up relatively well, another important complication arose when investors ran into liquidity issues.  When it would have been a good time to rebalance, assets in many of these programs were not available to make the needed buys.  Many of the management teams of these programs will correctly point out that the lack of access was a contributing factor to their strategy's survival, but one needs to be able to execute the needed transactions cheaply.  

Even less exotic holdings can be an issue.  Early withdrawal fees on CD's, surrender penalties in fixed annuity products, and the paperwork associated with making a change can also be obstacles to executing efficiently.

While the identities of A and B are critical to providing the ability to rebalance, the identities also impact one's willingness to act as the rebalancing discipline requires.

It is almost as predictable as the tides.  When markets become volatile, the reaction is the same.  The media and the public pay more attention to the markets.  The stories become those of dour conditions, devastating losses, and an uncertain future.  Extreme gloomy predictions get more attention as they seem more realistic.  The papers put a photo of a floor trader with a look of anguish and exhaustion on the front page after down days.  Anxiety rises, the infamous "this time is different" reappears, and many entertain the notion that things will never be better or at least won't get better anytime soon.

There is the heart of the willingness issue.  Mathematically, rebalancing in down markets improves the result when the asset that is bought rises above the level at which the buy occurs.  In the minds of many, the issue becomes if the asset will rise.