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The Essential Guide to Portfolio Rebalancing

Carton boxes labelled as different investment product categories on a laptop showing stock candle diagram. 3D illustration of well-diversified portfolios and the importance of asset diversification.
Unlocking Portfolio Growth: The Essential Guide to Rebalancing Your Investments

Unlocking Portfolio Growth: The Essential Guide to Rebalancing Your Investments

In my early days as a financial advisor, rebalancing was a term commonly discussed and systematically implemented for portfolio management. It involved adjusting the weightings of investments within a portfolio over time to realign them with the investor’s initial (and agreed upon) target allocation. For example, if a client's investment strategy aimed for a 60% allocation to stocks and 40% to bonds, shifts in market performance might have skewed this balance over time. Rebalancing would return the portfolio to the 60/40 allocation by selling the more appreciated asset classes and using that capital to invest in the portfolio’s underperforming asset classes.

The rationale behind period rebalancing is twofold:

  1. Maintaining Target Allocations: Rebalancing ensures that portfolios stay on target with their intended asset allocations, preventing an unintended increase in risk or volatility beyond the client's comfort level.

  2. Systematic Buying Low and Selling High: By systematically trimming overperforming assets and adding to underperforming ones, rebalancing aims to enhance long-term returns, in theory.

While these principles seem sound, recent market trends have challenged their effectiveness. Over the past decade, regular rebalancing may have hindered long-term returns. Selling outperforming investments (stocks) for underperforming ones (bonds) could have reduced overall returns, especially in a bull market where stocks flourished.

With the profitable surge in stock prices that began out of the Great Recession, many investors have neglected rebalancing, allowing their equity allocations to balloon. However, such distortions can jeopardize asset allocation and risk tolerance objectives. In buoyant markets like today's, the focus often shifts away from risk management until a significant market correction occurs.

Consider this: you may hesitate to sell part of your stock holdings, especially considering the tax implications (if held in a non-retirement account) and the allure of continued stock market gains. However, what's the cost of being wrong? Let's explore a scenario:

Imagine you began with a 60% stock and 40% bond allocation in your 401(k) years ago, which has now shifted to 80% stocks and 20% bonds due to the bull market in equities. Your 401k is currently valued at $600,000.

Bullish Scenario – Stocks increase 25% and Bonds increase 5%.

  • The 80/20 portfolio gain $126k

  • The 60/40 portfolio gain $102k Opportunity cost of rebalance = $24k

Bearish Scenario – Stocks fall 25% and Bonds increase 5%.

  • The 80/20 portfolio loss $114k

  • The 60/40 portfolio loss $78k Opportunity gain of rebalance = $36k

Two key points emerge:

  1. The dollar value of opportunity cost in bullish scenarios pales compared to the gains from rebalancing during bearish periods.

  2. The magnitude of percentage loss exponentially increases the required percentage gain to break even. For example:

    1. If you lose 13%, you will need to earn 15% to get back to even. (2% more)

    2. b. If you lose 19%, you will need to earn 25% to get back to even. (6% more)

Timing the market to sell or trim winners and reallocate capital to underperforming assets often feels counterintuitive. Yet, assessing the broader economic landscape, including interest rates, inflation, debt levels, and price-to-earnings ratios – all of which are flashing unfavorable conditions – can provide guidance for rebalancing decisions.

In conclusion, while it's tempting to continue to ride the wave of stock market success, prudent investors should consider reviewing their portfolio's asset allocation and rebalancing when necessary. We anticipate rebalancing Ranch Cap’s model portfolios in the near future. If you're unsure about the appropriate rebalancing strategy for your portfolio, don't hesitate to reach out for personalized guidance and support.


Gregg Pacitti CFP®


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