The saying “May you live in interesting times” is reputed to be an ancient Chinese curse. While the actual origin of this aphorism is in dispute, the saying itself is quite appropriate today. The past few years have seen spikes in volatility, dramatic swings in returns, and economic and political uncertainty. Beyond the emotional challenges they bring, these “interesting times” can quickly skew the asset allocation of a portfolio.
Asset allocation is a primary determinant of portfolio performance. Getting it right is worth all the time and energy you and your advisor devote to it. Factors include return needs versus your risk tolerance, liquidity requirements, time horizons and tax situation. As markets move, portfolios can rapidly move away from the target allocation, and during more tumultuous conditions those moves are more extreme. The result can be a portfolio that is no longer optimal, with risk and return characters potentially way out of synch with the original portfolio design.
Rebalancing brings the portfolio back in line with the plan on which so much time and effort were spent. Rebalancing simply means selling some of the securities in asset classes that have reached levels beyond the target allocation and buying securities in asset classes that have lagged. After rebalancing the distribution of asset classes is back in line with the initial portfolio plan.
In addition to maintaining the desired asset allocation, rebalancing serves several important roles for investors:
Diversification has been called “the one free lunch” in finance, providing a better risk and return trade-off than a more concentrated portfolio. Your original plan set a target allocation that provides appropriate diversification. Yet as markets move, the portfolio can become less diversified, with winners now a greater percentage and losers under-represented. Those assets that have appreciated the most now have an inordinate influence upon future portfolio returns. Rebalancing a portfolio restores the ideal diversification.
Buying Low, Selling High
All investors wish to buy low and sell high. Yet knowing when to sell winners and buy laggards is notoriously difficult. Rebalancing provides a systematic method to buy low and sell high. Appreciated positions are reduced, while depreciated positions are fortified. As numerous studies have shown, the “buy low, sell high” discipline from rebalancing can notably enhance returns versus simple buy and hold. These extra returns can be even greater with greater volatility, provided the rebalancing discipline is followed.
When markets are tumultuous, investors naturally become fearful and anxious. But letting your emotions take over in the short-term can lead to snap decisions that you may regret later. One needs to look back only to early 2009, when equity markets suddenly stopped falling and began a strong rally, to be reminded of the adverse consequences of selling at the wrong time. The erratic markets of the financial crisis left many investors and finance professionals wondering what to do. Rebalancing provided a systematic answer, one that did not rely on emotion: when allocations diverged significantly from portfolio targets, it was time to rebalance.
Selling off winners to rebalance can trigger tax costs, which should be considered in rebalancing decisions. Utilizing tax-deferred accounts is one way to minimize the tax bill. Rebalancing in volatile markets also offers the opportunity for tax savings via loss harvesting. Positions sold at a loss can be used to offset gains from elsewhere in the portfolio, such as from selling winners in rebalancing. The tax savings from loss harvesting can be substantial, and the greater the volatility the greater the opportunity.
Tumultuous markets can create a sense of crisis, but they also create opportunities. Rebalancing brings many benefits, and these can be even more powerful in the face of greater volatility. Investors who take advantage of these benefits create opportunity where others see only danger.