It’s considered prudent to rebalance when the markets rise or fall. But that’s what people usually say when markets are calm. 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, rebalancing provides one sure benefit and two possible benefits. It definitely allows long-term strategic investors to control their exposure to risks. It may also improve returns and may help take the emotion out of decisions.

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 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,” a group of broadly diversified stocks. Let’s say “A” earns 4% while “B” loses 20%. What’s left is $184,000 (“A” is now worth $104,000 while “B” is worth $80,000). The portfolio is down 8%, and what’s left is a mix of 57% in investment “A” and 43% in investment “B.”

The portfolio is now 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.

Return Enhancement
Several studies (including the work of researchers Gobind Daryanani, Marlena Lee and David Blanchett) show that a portfolio’s returns can be improved with rebalancing. It’s not something that happens over all time frames, but it has been shown to work when investors buy at a time prices are declining.

Take our portfolio with investments “A” and “B.” Let’s assume that we don’t rebalance, and our fixed-income basket “A” again rises 4%. It’s now worth $108,160. Our basket of stocks, “B,” would have to rise from $80,000 to $91,840, or by 14.8%, for the portfolio to reach the original $200,000.

If we did rebalance, however, that means we sold $12,000 of “A,” meaning 4% growth on $92,000 would leave it worth only $95,680. Therefore, the “B” stock basket must rise to $104,320 to put the portfolio back to $200,000. Because we bought $12,000 more of “B,” it needs to rise only by 13.39% ($104,320 minus $92,000 divided by $92,000).

Because we rebalanced, the portfolio recovers faster. However, after “B” increased 13.39%, if we were to calculate its per share price, it’s still off by 9.29% from its starting point. The portfolio is whole, yet the offending holding is barely halfway recovered.

Taking Emotions Out Of Decisions
In our scenario, we made no mention of the amount of time or what happened between transactions. The “B” investment could have gone far lower or higher or just muddled around. The math holds, and rebalancing accelerates portfolio recovery no matter whether the recovery is quick or whether it occurred before, at or after a bottom.

However, 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. It might not be clear to a lot of clients how the rebalancing has helped them manage risk. Few of them will want to “throw good money after bad” or “catch a falling knife” as pundits discuss things like “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 if, 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 keep us from feeling paralyzed when facing these questions and encourage prudent trade execution regardless of whether it is scary to do so.

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

If they rebalance too early, for example, they fear losing more money. That fear is often exaggerated, however. If there is another decline, the entire equity position is still going down. The additional loss from the rebalancing is only on that we’ve purchased, for example the loss on the $12,000 purchase in our example of stock basket “B.”

It is also important to note that the performance of the fixed-income securities in a portfolio matters too. Take our hypothetical portfolio. If basket “A” in our example had produced a zero return in both periods, our $200,000 would have fallen to $180,000. The stock portfolio “B” would need only an additional $10,000 to rebalance the portfolio to 50/50, with both sides now $90,000. For the portfolio to recover fully and reach $200,000 again, the $90,000 in stock basket “B” would then need to rise 22.22% to reach $110,000 (assuming portfolio “A” is doing no work).

The per share price of investment “B” is now a mere 2% down from its original value, whereas it was down 9.29% in our previous example. Likewise, if the “A” fixed-income basket earned 8% in both periods, the rebalancing would have required moving $14,000 from investment “A” to investment “B” and the portfolio would have recovered when “B” was still about 16% from its original per share price.

I would caution against any reader interpreting this to mean today’s low-interest-rate 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 four years for 2% of earnings to compound to a cumulative 8% increase.

Higher returns still mean higher risk. If our investment “A” decreased in value, it would take even less for us to rebalance and buy shares of “B.” 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 26 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 there would be no need to rebalance into the S&P 500 fund.

Maybe high yield will come back along with the stock market. Maybe it won’t. Nonetheless, a lower risk, more stable fixed-income allocation in which half was in T-bills and half was in the SPY fund would have fallen by only single digits and given an investor some buying power at the proper time.

Research indicates that rebalancing when the relative weightings are far out of whack produces better results than calendar-based rebalancing. For instance, Gobind Daryanani recommends tolerance bands of 30%.

I find it interesting that in the current market crisis, there are a greater number of clients looking to rebalance than those that did in 2008-2009. This might be because of our frequently repeated policy: “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 stocks declined 20%—reaching the “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 than it would have had it been rebalanced back to 50/50 or not rebalanced at all. However, when we looked at more severe downturns and set a 40% market decline as a trigger, 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. And rebalancing after a 40% market decline is something few clients can or would do. In 2008, the shift to a 60/40 target required selling 40% of a bond position and increasing equities by 78% of their pre-rebalance value.

Nonetheless, in a time when clients want to “do something,” our study suggests that rebalancing during a bear market will not likely hurt much more than doing nothing. But the study also 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 necessary 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, is an independent financial advisor. He practices in Melbourne, Fla. You can reach him at [email protected].