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%.