Famous economist, John Maynard Keynes, once said, “The market can remain irrational longer than you can remain solvent.” Basically, what he’s saying is that we don’t know what the market is going to do, or how and when it’s going to do it.
As a CERTIFIED FINANCIAL PLANNER™, I am well versed in the world of finance and investing. Even with more than 20 years of experience and expertise under my belt, I can honestly say, I don’t have a clue what the market is going to do because it is irrational. We can examine historical figures, charts, and market trends, but in the end, the market’s going to do what it’s going to do and none of us has a handle on how to accurately predict what it does next. So, what do we do with such uncertainty? How can we invest with confidence when the market is so irrational?
First, you can mitigate the risk of your portfolio through diversification. By spreading allocations across multiple asset types and classes, you can limit the impact one position has on your portfolio as a whole. But beyond diversifying your portfolio, we use a concept called rebalancing. What rebalancing means is that we restore the order or put things back as they were.
For example, let’s say that you have a portfolio that’s split 50/50 with stocks and bonds. Over time, you may find that your stocks have grown and now your portfolio is 60% stocks and only 40% bonds. Therefore, your portfolio is out of balance. The simple fix is to sell the percentage of stocks that are causing you to be out of balance, and therefore, rebalancing your portfolio.
In the simplest terms that I can think of, we rebalance to avoid finding ourselves in a position where we’re taking on too much risk. Depending on the market, it’s possible that your stocks will outperform your bonds. So, you could easily find yourself in a situation where your 50/50 portfolio is suddenly 70/30 in favor of stocks. Conversely, in the bear market of 2008-2009, you could have just as easily found yourself owning a 25/75 portfolio that favored bonds. In this situation, you want to capture that alpha potential and buy the stock when it’s low. It’s a simple and basic concept, and that’s why I like it. We want to buy low and sell high and that’s why we rebalance.
At this point, you might be thinking that rebalancing sounds like a brilliant and perfect plan. Right? Not so much. When we rebalance, we’re going to hurt the returns over time. But if we’re buying low and selling high, we’re turning a profit. How’s that bad? It’s not, but studies have shown that if you simply leave the portfolio alone, you can expect a larger return.
If you think about it, it makes sense. Let’s say that your stocks have grown and now your portfolio is 80% stocks and 20% bonds. Because of the higher risk associated with stocks, it stands to reason that there’s a potential for a greater return. However, you will probably not see that return on investment if you rebalance. Therein lies the problem. If you leave it alone, you open yourself up to all kinds of risk but if you rebalance, you diminish your returns. So, what do you do?
If the position’s expected return is similar (think large-cap and mid-cap stock growth), if they have high volatility or low correlation (meaning they don’t move in tandem), then they’re good for rebalancing. However, if they have different expected returns, low volatility — looking at you, bonds — or they move in tandem with one another, then they are bad for rebalancing.
So, we know that we should rebalance. We understand that in doing so, we are going to give up some of our potential returns. That leaves the question of timing. If it has to be done, knowing when to rebalance can maximize your potential for growth while mitigating the amount of time you leave yourself open to significant risks.
Vanguard was involved in a study looking at how often we should rebalance our portfolios. They ran several different trials, each with varying results. The first trial that they tested was never balancing your portfolio. What they found was that, during this timeframe, the average rate of return was 9.1%.
Next, they examined annual rebalancing. So, operating off of the calendar year, they rebalanced once a year on the same date. Annual rebalancing netted an 8.6% annual rate of return. The study continued with quarterly rebalancing and finally, with monthly rebalancing. The results were an annual rate of return of 8.6% and 8.5%, respectively.
Going by these numbers, there’s not much difference between never rebalancing and doing so on a monthly basis. If you’re involved in a 401(k), chances are you’ve already selected a rebalancing schedule. But is there a better way?
According to the same Vanguard study, if you rebalance your portfolio, you could miss out on 0.5% to 0.6% of your returns. That’s not insignificant. So, how can you rebalance your portfolio in a way that protects you from unwanted risk without forcing you to sacrifice returns?
That’s where target-band rebalancing can help. Essentially, a target-band analyzes the various positions and sets a strategic target so that when the position reaches that target, the target-band automatically sells the position and buys another.
According to studies by Gobind Daryanani, CFP®, Ph.D., you can actually net a 0.38% larger return with a target-band and an advisor than with a simple buy and hold strategy. Target-band basically buys the position that is low and sells the position that is high, across multiple asset classes. I know I used an example of a portfolio composed of stocks and bonds, but the average portfolio is made up of much more than just two asset types.
The average portfolio contains 6-12 different asset types. This makes manually tracking each position quite difficult. However, we have found that, by placing a band of about 20% — high-water mark and low-water mark — on each position, it doesn’t matter if we rebalance monthly, quarterly, or every five years. You could actually rebalance every day with the target-band, and we have software that helps us to track every position in real time.
Target-band rebalancing is a great way to minimize your risk without sacrificing returns. However, as with any investment strategy, you should consult your financial planner to see how it could fit into your specific financial plan.
Justin Goodbread CFP®, CEPA®, CVGA®, at Heritage Investors, LLC, is a financial educator, wealth manager, author, and speaker.
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