In “Rebalancing in a bear market,” I pointed out that two of the most often cited benefits to rebalancing, returns enhancement and taking emotion out of rebalancing, were not certainties. The action in financial markets during the Coronacrash and the subsequent upturn in stocks provides us with some real-life examples of how the two benefits are intertwined. Before I get to the actual cases, a quick recap on how rebalancing during bear markets is supposed to help is in order.

Returns are enhanced through rebalancing in bear markets because additional shares of equities are bought. As a result, the price of the equities does not have to rise back to a prior high point for a portfolio to fully recover.

If we determine that 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. 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.

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% ($104,320-92,000/92,000). 

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 when the portfolio fully recovered. The portfolio is whole, yet B is barely halfway recovered.

From a behavioral standpoint, we crave control especially when things seem out of 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 either reward or punish us. Rebalancing exercises that control and is supposed to help people overcome emotional decisions. When the market is down, negativity abounds. A rebalancing policy may provide enough rationality to allow the exercise of discipline in real time when emotions are high and the policy actions are most needed.

Our rebalancing policy is straightforward. Because research supports it, we set tolerance bands and use our technology to alert us when portfolios are out of balance, what trades are indicated, the costs of the trades and the tax ramifications. Based on this information, we can identify needed adjustments based on each client’s unique circumstances.

So, what happens in real life? Within our client base of over 600 families we see the effects of having a sound policies and either following them or not. In none of the following examples were any transactions executed at the bottom. Calling a bottom is not necessary for rebalancing to be beneficial.

A very strong majority of our clients saw their portfolios rebalanced with the purchase of more equity sometime during March or early April. For most households, rebalancing was performed without any comment from the client. We believe consistent and repeated messaging about how markets should be expected to be volatile and what actions are prudent when markets drop contributed to the lack of comments. We also believe had the market declined further or meandered instead of bouncing back as quickly as it did, we would have heard more about rebalancing from clients.

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