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.