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Investment Concepts: Keeping a Healthy Balance

Mar 25, 2020 | Financial Concepts

The aims of a diversified portfolio and how it works can be difficult for many investors to understand and in particular a concept that often trips up investors is the concept of “rebalancing”. Rebalancing generally means selling stocks while they are going up and buying them when they are going down.

The first goal of rebalancing is to ensure that investors are not taking more risk than they should or are comfortable with.

For instance, a $10,000 simple portfolio invested in half US stocks and half bonds illustrates this most clearly. If the investment started in January 1987 and was left untouched until the end of 2019, it would’ve ended up as approximately 79% stocks and 21% bonds: meaning that it would have been more risky than an investor originally intended. By rebalancing, that portfolio would stay in line with the targets and give the investor the protection they thought they were getting for down markets. As of writing on March 19, a 50/50 (using VT for the total stock market and BND for the bond portion) portfolio on January 1 would be down only 14.6% versus 21.3% for an unrebalanced balanced portfolio (and 26.2% for an all stock market portfolio) year-to-date.  

Rebalancing then provides insurance on the downside: if disciplined, investors will lose less money when the market goes down. However, there is a less remarked upon side to rebalancing: it means the portfolio potentially will recover more quickly.  

To turn back to the two most recent market downturns (that of 08-09 and 00-02), a 50/50 diversified portfolio returns to flat much more quickly than one without rebalancing. For a non-rebalanced 50/50 portfolio first invested in 1987, the portfolio would have a “drawdown” (or decline off of its peak) of 33.96% in February 2009. The portfolio would recover to its original levels in January 2011. If the same portfolio were rebalanced quarterly, it’s drawdown would be 26.45% and it would return to it’s previous levels by April of 2010. The recovery time for a similar portfolio that was first invested in January 1987 and rebalanced quarterly during the bear market of 2000-2002 would’ve been 12 months less (November 2003 versus November 2004 for an unrebalanced portfolio). 

The case for rebalancing can be made in a variety of ways on paper, but putting the rebalancing in practice can be tricky, taking into account the tax ramifications (this is particularly tricky for US expat clients as they have to take into account tax rules both in the United States and abroad) and the varying time horizons for the variety of cash needs required. However, those who haven’t prepared their portfolio in the face of a downturn by rebalancing, can, hopefully, improve their recovery time by turning to a financial advisor who takes into account their individual challenges but still maintains the discipline needed.

Keith Poniewaz

 

Disclosure note: These securities mentioned were meant to be illustrative in nature only and were not meant to be advice or an inducement for someone to purchase it. You should consider your own personal situation and expertise of a trusted advisor before you implement any investment strategy. The rates of return quoted here are thought to be reliable, but there is no guarantee that they are correct. Again, it’s the premise we are trying to show rather than the actual numbers.