Even after a year with market returns as exceptional as 2020, some anxieties are perennial: Is now a good time to rebalance your portfolio?
The big fund companies certainly beat the drum on the subject, advising investors to sell their winners and buy their losers at least annually, if not every quarter (and generate some trading fees in the process).
But dig into the data and you’ll find ample reason to consider if rebalancing that often—or even at all—is necessary, even during times of heightened market volatilityA measure of how large the changes in an asset’s price are. The more volatile an asset, the more likely that its price will experience sharp rises and steep drops over time. The more volatile an asset is, the riskier it is to invest in. such as we experienced in 2020.
Rebalancing advocates tout its riskThe probability that an investment will decline in value in the short term, along with the magnitude of that decline. Stocks are often considered riskier than bonds because they have a higher probability of losing money, and they tend to lose more than bonds when they do decline. control benefits—maintaining a target allocation between stocksA financial instrument giving the holder a proportion of the ownership and earnings of a company., bondsA financial instrument representing an IOU from the borrower to the lender. Bond issuers promise to pay bond holders a given amount of interest for a pre-determined amount of time until the loan is repaid in full (otherwise known as the maturity date). Bonds can have a fixed or floating interest rate. Fixed-rate bonds pay out a pre-determined amount of interest each year, while floating-rate bonds can pay higher or lower interest each year depending on prevailing market interest rates. and other asset classes can effectively manage the overall risk in your portfolio across market cycles. For example, say you start out with a basic 50%–50% mix of stockA financial instrument giving the holder a proportion of the ownership and earnings of a company. and bondA financial instrument representing an IOU from the borrower to the lender. Bond issuers promise to pay bond holders a given amount of interest for a pre-determined amount of time until the loan is repaid in full (otherwise known as the maturity date). Bonds can have a fixed or floating interest rate. Fixed-rate bonds pay out a pre-determined amount of interest each year, while floating-rate bonds can pay higher or lower interest each year depending on prevailing market interest rates. funds in a portfolio. After a period when stocks outperform, it may become skewed to a 60%–40% or 70%–30% mix, leaving you at increased risk of shedding those gains if stocks drop. That’s the essence of rebalancing theory: Keep allocations in check, thus reducing risk. On the face of it, that’s solid (if superficial) advice.
Testing Rebalancing Scenarios
We’ve seen Fidelity and Vanguard address rebalancing over the years, typically recommending folks rebalance either on a semiannual or annual basis, or when allocations drift more than 5%-10% from their targets.
To check their thinking, we built a hypothetical portfolio of index funds with a 50%–50% split between stocks (Vanguard 500 Index) and bonds (Vanguard Total BondA financial instrument representing an IOU from the borrower to the lender. Bond issuers promise to pay bond holders a given amount of interest for a pre-determined amount of time until the loan is repaid in full (otherwise known as the maturity date). Bonds can have a fixed or floating interest rate. Fixed-rate bonds pay out a pre-determined amount of interest each year, while floating-rate bonds can pay higher or lower interest each year depending on prevailing market interest rates. Market Index) and tracked the results of several rebalancing scenarios over the past 20 years.
In scenario 1, we rebalanced the portfolio every six months, in January and July. In scenario 2, we rebalanced annually at the start of the new year. In scenario 3, we rebalanced every three years in January. (We picked January because it’s preferable to rebalance following December distributions and after the tax year has turned.)
We looked at returns for each scenario over 20 years. Over shorter periods, some of the rebalancing strategies posted slightly better returns—this time around, the roaring bull marketA period during which stock prices rise significantly from recent lows for weeks, months or years. in stocks in the second half of 2020, despite the pandemic-induced drop in March, helped the annual rebalance strategy post the best overall gains, with the semiannual rebalance strategy coming in a close second. But no matter which period we looked at, the average annual returns are all very similar, with just 0.39% separating the best performer from the worst.
We do see somewhat wider swings when comparing the best and worst periods. For example, the 39% swing from best to worst year for the portfolio that was never rebalanced compared to a 36% to 37% swing for the three regularly rebalanced portfolios. So rebalancing does appear to have a positive effect on a portfolio’s volatility—you won’t hit the same heights, but you are also unlikely to see the same losses.
On the other hand, the slight course correction rebalancing offers can’t do much to overcome a truly huge wave: The brief but sharp market correction at the end of 2018 left all the portfolios down between 2.1% and 2.8% for that year. When the stock market came roaring back in 2019, all soared with it, up between 19.8% (frequently rebalanced) and 22.5% (unbalanced).
Frequently rebalancing a portfolio does help it stay much closer to its target allocation, but results can still be impacted by periods of high market volatility. Through December 2020, the portfolio that was never rebalanced ended up with a roughly 67.3%–32.7% split between stocks and bonds. The most frequently rebalanced portfolio—most recently in July 2020—ended up much closer to its original allocation with a 54.7%–45.3% stock/bond mix. But even frequent rebalancing cannot entirely protect you from the market’s wild ride: The 1-year and 3-year portfolios both ended 2020 with a 52.4%–47.6% allocation, with the sharp rebound in the stock market in the second half of the year helping to tip the portfolio that was rebalanced in July ahead of the others.
This chart tracks the growth of $10,000 in our hypothetical portfolio split between stocks and bonds using various rebalancing schemes. Over the long haul, it’s not clear that rebalancing is worth the cost. By December 2020, the never-rebalanced portfolio held assets worth $35,471.57, while the semiannually rebalanced portfolio’s value was $36,128.12, a difference of $656.55 or about 1.8% over 20 years. Rebalancing annually, however, offered the best performance of the styles we tested, netting $37,217.09 over the 20 years, 6.6% better than rebalancing every three years.
Is the Portfolio Drift Method a Better Rebalancing Technique?
So what if you followed Fidelity’s and Vanguard’s recommendation? Rather than use a set time period to decide your rebalancing strategy, you use portfolio drift—rebalancing when the spread between stocks and bonds exceeded 5% or 10% as a result of market activity?
The Portfolio Drift Method’s Impact on Performance
Looking at just the number of trades and the average months separating them, Fidelity and Vanguard’s approach seems doable—with a 5% spread threshold, you would’ve traded about once every 4 months. Up it to 10%, and you’d trade once every two years.
But that’s misleading. The frequency of trades varied significantly over the 20-year period, with a few periods requiring a flurry of trades after longer gaps with no trades. For example, with a 5% threshold, from January 2008 to January 2010, you would have made 12 trades as stock market declines regularly pushed the balance of the portfolio towards bonds. That means you would’ve had to face the daunting psychological task of putting more money into stocks 12 times as their value was falling. Would you have been disciplined enough to make all those painful trades during volatile periods, knowing that from a return standpoint, the average annualized returns are similar?
The results of our analysis suggest that the performance of each rebalancing method may depend more on the vagaries of market timing, rather than representing a statistically sound strategy. The last time we did this analysis, in 2018, the results made a stronger argument for the never rebalancing approach. When we looked in early 2016, however, the long-term returns were nearly identical across the board—so back then, it would have been fair to say that rebalancing worked as intended. (Indeed, taking a broader view, a start date of 20 years ago is just in time for the stock half of our portfolio to take the full brunt of the Dot-Com Bust, sapping overall returns for our unbalanced portfolio.) Former Vanguard Chairman Jack Bogle summed it up nicely a few years back: “Rebalancing is a personal choice, not a choice that statistics can validate.”
More to Consider with Rebalancing Strategies
This week we looked strictly at returns and found neither a convincing argument for nor against frequent rebalancing—but there’s more to this than just performance. In an upcoming Adviser Fund Update, we’ll have more on the subject, including key concerns that anyone developing a rebalancing strategy needs to consider. Stay tuned!
Podcast: The 7 Habits of Highly Effective Investors
New Year’s resolutions often turn out to be lofty promises we make to ourselves and have a hard time keeping. But break those big pledges down into smaller, repeatable habits and you are far more likely to make them part of your year-round routine.
If you’ve resolved to get your portfolio in shape for 2021, Vice President Rick Winters and Senior Financial Planner Andrew Busa are here to help. In the year’s final episode of The Adviser You Can Talk To Podcast, they lay out seven steps for investors to consider as we close the books on 2020—and they are equally applicable throughout the year.
In this lively conversation, Rick and Andrew explain:
The importance of knowing when mutual funds pay out distributions
Why to be proactive about “tax-loss harvesting”
Different strategies for taxable accounts and tax-preferred retirement accounts like 401(k)s and IRAs
To find out more about effective portfolio management and to hear our financial planning professionals’ money-saving tips, click to listen now!
Adviser Investments’ Market Takeaways
There’s no shortage of hyperbolic headlines and provocative punditry in the financial media. But you won’t find such hysterics here. In Today’s Market Takeaways, members of our investment team provide timely videos that clearly and concisely explain what we’re seeing in the markets.
We hope you find them engaging and accessible, and please let us know if there are any topics you’d like to hear us address by sending an email to firstname.lastname@example.org!
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