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Portfolio Rebalancing: Money, Mind And Moods

Maybe you’ve never won a lottery Powerball, but you’ve probably at least imagined what it might feel like to shout out, “Drinks on the house!” Actually, you don’t have to imagine too hard, because this is the same giddy mindset that investors periodically face when making decisions about their investment portfolios. While it’s pleasant to daydream about euphoric wins in everyday life, it can be dangerous when applied to prudently managing your life’s savings. That’s why it’s important to be aware of how your mind and your moods interact with your money — especially as they relate to portfolio rebalancing.

Defining Rebalancing: Buying Low, Selling High

In accordance with our recommended approach to investing , rebalancing is a key component to wise portfolio management. We begin by constructing a globally diversified portfolio to dampen market risk. Your mix is defined by your personal goals rather than the whims of an ever-changing market. We use investment solutions dedicated to efficient, low-cost exposure to the kinds of market risks and expected rewards that make sense for you.

So far, so good. But then what? Let’s say we build a portfolio that is half stocks and half bonds. Within your stock holdings, we assigned 70 percent to U.S. securities and 30 percent to international. Among these, we further slice your pie among riskier/safer asset classes.

Then, imagine that we go through a stock boom or bust, or that international is on a tear, or that the S&P 500 is having its day in the sun. As time marches on, the percentages we carefully established begin to shift. Instead of owning half stocks and half bonds, you may find yourself with 60 percent stocks and 40 percent bonds. This is not because you or your fund managers have lifted a finger. It’s simply the market doing its thing, with you along for the ride.

Rebalancing is the act of deliberately selling your recent high-flyers and buying recent underperformers, to bring your portfolio back to your targeted allocations. In the simple, 60/40 illustration above, it’s selling about 10 percent of your stocks and buying more bonds with the proceeds, until you’re back to your desired 50/50 mix.

Can you see what just happened? Rebalancing forced you to buy low and sell high! Who wouldn’t agree that this is a good idea? And yet, many investors don’t rebalance. Now let’s explain why they don’t.

Investor Mindsets

As is so often the case in investing, there is logical decision-making … and then there are our minds and moods playing tricks on us. Think of how you feel when you’re on a winning or losing streak. When you’re winning, you want to keep on winning. When you’re losing, you want to escape. In portfolio management, when a holding has been doing well, we don’t want to sell it, even though it means we’re selling high. When a holding has been in the dumps, we are afraid to buy it. If anything, we want to get rid of it, fast.

Dr. Jason Hsu, Chief Investment Officer for Research Affiliates, describes this behavior in his article, “Why We Don’t Rebalance .” He also reminds us of a critical point, also based on ample academic evidence: Odds are that losing asset classes are more likely to experience higher future returns than their winning counterparts. As Hsu explains (emphasis is ours), “When investors rebalance into fallen assets and away from safe assets, they also rebalance into high forward return assets and away from low forward return assets. This practice generates better portfolio performance over time than a buy-and-hold approach.”

Additional Challenges: Trading Costs and Short-Term Noise

Ah, but that “over time” caveat in Hsu’s article is an important one. There are additional hurdles to effective rebalancing.

It takes real guts to sell what’s been working well and buy what everyone else is fleeing. To heighten the challenge, there are short-term market movements at play in the form of momentum and economic distresses that can cause rebalancing to disappoint in the short-term. In other words, a newly rebalanced portfolio may underperform an untouched portfolio for a little while. Then, like a great ship navigating in the night, it is expected to change course and come out ahead in the long run. Not surprisingly, it takes a leap of faith to invest in these kinds of results.

There is one more consideration in effective rebalancing: It costs money to trade. Even if you’re buying low and selling high, it makes sense to rebalance only when the benefits are expected to handily outpace the trading costs involved.

How do you assess when that is? That’s when it comes in mighty handy to have an experienced advisor to assist you in the analysis involved.