The Case Against Rebalancing Your Portfolio
Common wisdom in investing tells us that we should set a target asset allocation in our portfolios and periodically rebalance to ensure our portfolio stays in line with our allocation goal. But does this always make sense? While the reasoning behind rebalancing is sound, it might lead to lower returns in your portfolio over time.
Portfolio Rebalancing 101
Before we talk about why portfolio rebalancing can be bad, it is important to understand the concept and why most investment managers are in favor of the strategy. Rebalancing is the process of selling some assets and buying others to bring your portfolio in alignment with a target asset allocation, like a specific percentage of stocks and bonds.
Asset allocation exists to help avoid risk and reach specific investment goals. Bonds are considered a low risk asset, but generally pay a relatively low return compared to stocks. Stocks are considered higher risk, and offer a higher return. Depending on your age and goals, you likely want a specific percentage of your portfolio in stocks and a specific percentage in bonds to help you reach optimal gains while limiting risk. For example, a younger investor might have a target allocation that is 80 percent stocks and 20 percent bonds, while an investor reaching retirement might want 60 percent stocks and 40 percent bonds.
There is no right or wrong allocation, just what makes sense for the specific investor’s scenario.
But over time, asset allocations tend to drift away from the target. This makes sense, as different asset classes provide different returns. If your stocks offer a 10 percent return over a year while your bonds return 4 percent, you will end up with a higher percentage of stocks and lower percentage of bonds than you started.
This is when most people would tell you to rebalance. They say you should sell some stocks and buy some bonds to come back into your target allocation. But there’s a downside hiding in plain sight: When you do this, you’re selling an asset that is performing well to buy more of an asset that is underperforming!
This is the core of the case against portfolio rebalancing.
The Fine Line Between Risk Management and Profit
The purpose of a target allocation is risk management, but that leads to owning more of something that makes you less money. Here is an example, with fictional numbers explaining how it works:
Let’s say you have a $10,000 portfolio that is 80 percent stocks and 20 percent bonds. Over the year, your stocks return 10 percent and bonds return 4 percent. At the end of the year, you have $8,800 in stock and $2,080 in bonds. That is a pretty good year overall, at the end you have $10,880. But now you have about 81 percent stock and 19 percent bonds. Rebalancing says you should sell some of that $800 profit from your stocks to buy more bonds.
But if you do that, you will have more bonds that paid you 4 percent, and less invested in those stocks that paid you 10 percent. If the same thing happens next year, selling stocks to buy more bonds leads to a lower total return. While in this example the difference might be a difference of less than $100 over a year, your investment time horizon is far longer than one year. In most cases, it is decades. If you were to lose out on just $25 per year over 30 years at 6 percent interest, that is about $2,000 in losses.
Bigger dollars and interest rates make the disparity even more harmful to your portfolio.
This effect isn’t limited to stocks versus bonds. Over the last five years, the S&P 500 has far outperformed emerging markets, with an 89 percent five year return on the S&P 500 compared to just 22.4 percent from a popular emerging markets index. If you were to have sold the S&P to buy more emerging markets, it would have cost you big time over the last five years.
Of course, asset allocation is rooted in the idea that maximizing returns isn’t the only objective of an investing strategy: You also want to manage risk, especially if you’re getting closer to retirement and wouldn’t have time to recover from a significant loss in the market. As such, rebalancing is more important as you get older, and more worth the downside of selling off a well-performing asset. Consider motif investing as well.