When markets are relatively calm, rebalancing is talked about as a prudent action after markets rise or fall. Now, when the bear is growling, questions arise. New and experienced advisors alike seem puzzled about rebalancing when the economy, financial markets and life in general seem anything but in balance. 

From what I can see in the literature and what I have experienced personally over the past 30 years is that rebalancing provides one sure benefit and two possible benefits. Rebalancing definitely permits long-term strategic investors to control their exposure to risks. It may provide return enhancements and it may help take emotion out of decision making.  

Risk Management
Rebalancing keeps a portfolio’s structure in line with its targeted mix of investments. Staying aligned with the target is important because good financial planning establishes the target based on client goals. Straying too far from targets can be costly and potentially cause a client to fall short of their goals. 

For this discussion, let's say a $200,000 portfolio should hold half its assets in “A”, a fairly stable basket of high-quality fixed-income securities and half in “B”, broadly diversified stocks. A earns 4% while B loses 20%. The total is $184,000 (A=$104,000 and B=$80,000), down 8% with a 57% A to 43% B mix. 

It is overexposed to the risks and potential return of A and underexposed to the risks and potential return of B. To rebalance, $12,000 of A is sold to buy $12,000 of B, leaving $92,000 in each. The portfolio is back to 50/50 and the desired risk exposures are maintained. 

Returns Enhancement
Several studies show that returns can be enhanced through rebalancing (Daryanani, Lee, Blanchett). These benefits do not appear in all periods but buying when prices decline is a feature of most good periods. 

Back to our example. Without rebalancing and assuming A again rises 4%, A would be worth $108,160 and B would have had to increase to $91,840, or 14.8% for the portfolio to reach the original $200,000. 

Because we sold $12,000 of A to rebalance, another 4% will only make it worth $95,680. Therefore, B must rise to $104,320 to put the portfolio back to $200,000. Because we bought $12,000 more of B, it only needs to rise 13.39% ($104,320 minus 92,000 divided by 92,000).  

By rebalancing, the portfolio recovers faster. In fact, at a rise of 13.39%, the actual price of B would still be off by 9.29% from its starting point. The portfolio is whole, yet the offending holding is barely halfway recovered. 

Taking Some Emotion Out Of Decision-Making
In our scenario, we made no mention of the amount of time or what happened between transactions. B could have gone far lower or higher or just muddled around. The math holds and rebalancing accelerates portfolio recovery no matter if the recovery is quick or not or whether it occurred before, at, or after a bottom.

Since our hypothetical client has lost $16,000 and is buying $12,000 more of the very thing that caused the loss, there may be some angst. How rebalancing provides “risk management” may not be clear to a lot of clients. 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” or similar things. When the market is down, the negativity increases. A successful investment experience requires making real-time decisions about an ongoing series of unprecedented events.

Advisors must temper their own anxiety as well. The recent volatility has many doubting whether, when and how exactly they should execute the trades. 

When conditions are particularly chaotic, we crave control. We cannot control when, or even whether, we are rewarded for risk taking. But we can control the types and levels of risks we bear and how we behave when those risks reward or punish us. A rebalancing policy should exist in part to avoid paralysis over these questions and encourage prudent trade execution regardless of whether it is scary to do so.

Other Insights 
One thing clients crave when experiencing a decline in portfolio value is to erase the loss as fast as possible. Rebalancing can help. Despite this, many are anxious about rebalancing because the other thing investors want after a decline in portfolio value is to not lose any more value. 

Often this fear of additional loss is worse than the actual losses incurred when one rebalances “early”. If no rebalancing had occurred, all of the rest of the equity position would still have gone down. The actual loss from rebalancing is just the loss on the $12,000 purchase in our example. 

It is also important to note that the performance of the fixed-income securities in a portfolio matters, too. If A in our example had produced a zero return in both periods, the needed buy of B to get back to 50/50 would only have been $10,000. To recover fully, B would then need to rise 22.22%, which would occur roughly a mere 2% from its original value, not the 9.29% in our example. Likewise, if A earned 8% in both periods, the buy would have been $14,000 and the portfolio would have recovered when B was still about 16% from its original value. 

I would caution any reader from interpreting this to mean today’s low-interest environment is an impediment or that one should seek higher returns from fixed income. Recall, there are no time frames in these examples. It takes less than 4 years for 2% of earnings to compound to a cumulative 8% increase.

Higher returns still mean higher risk. If A decreased in value, the buy of B would be even less. Anyone who stretched for yield by loading up on low-credit-quality debt recently may have torpedoed their ability to effectively rebalance now. High-yield bond funds have been slammed in this Coronacrash. The price of the SPDR Bloomberg Barclays High Yield Bond ETF (JNK), an ETF that tracks high-yield bonds, was down over 18% year to date as of March 26th when the S&P 500 was off 19%. A 50/50 split of the SPDR S&P 500 ETF (SPY) and JNK at the beginning of 2020 would still be nearly 50/50 now and no buying of SPY would occur.

Maybe high yield will come back along with the stock market. Maybe it won’t. Nonetheless, a lower risk, more stable fixed-income allocation like 50/50 T-bills and SPY would only have been down single digits and possessed some buying power at a time when buying is indicated.

As to when to rebalance, prior research indicates that rebalancing when the relative weightings are far out of whack produces better results than calendar-based rebalancing. For instance, Daryanani recommended tolerance bands of 30%.

I find it interesting that through this Coronacrash, a significantly higher percentage of clients are looking to rebalance versus what I experienced in 2008-2009. I believe this is partly due to repetition. A short version of our frequently repeated policy is “always expect volatility from stocks and when (not if) stock markets get ugly, expect us to rebalance.” Some clients are downright enthusiastic about buying now.

A couple of years ago I wondered, "If holding is good and buying is better during a bear market, would buying even more be even better?" My business partner Mike Salmon and I looked at the question and wrote a paper, “Analyzing the Effects of Aggressive Rebalancing During Bear Markets,” which was accepted in mid-2019 and published in the January issue of the Journal of Financial Planning. We wanted to see what would happen if instead of rebalancing back to a 50/50 target, we increased the equity target to 60/40 as soon as a decline in stocks reached the down 20% “bear” threshold.

Historically, it turns out that getting more aggressive usually helps but only a little. In most past bear markets, the portfolio recovered a month or two earlier. However, when we looked at more severe downturns and set the trigger at down 40%, the improvements were substantial.

Keep Calm And Carry On 
We don’t advocate “aggressive rebalancing” as we dubbed it to be any advisor’s standing policy. More research needs to be applied to the concept. More importantly, actually making the shift we illustrated when markets decline 40% is something few clients can or would do. In the 2008 period, the shift to a 60/40 target required selling 40% the bond position and increasing equities by 78% of its pre-rebalance value. 

Nonetheless, in a time when clients want to “do something,” our study suggests that rebalancing during a bear market is not likely to result in an inferior outcome versus not rebalancing at all. Moreover, it suggests advisors can’t fix a bad situation through portfolio adjustments. Other actions financial planners recommend to clients—such as saving more, spending less, managing taxation or working longer—should be more impactful. 

The point of having financial planning policies is to define and encourage needed actions that can be tough to execute. If you didn’t have a rebalancing policy before this, it is not too late to establish one and communicate it to clients. You will surely need it at some point. This bear may not be done and another one will surely come.

Dan Moisand, CFP® has been featured as one of America’s top independent financial advisors by Financial Advisor, Financial Planning, Investment Advisor, Investment News, Journal of Financial Planning, Accounting Today, Research, Wealth Manager, and Worth magazines.  He practices in Melbourne, FL.  You can reach him at [email protected]