Investing isn’t a one-and-done activity. Choosing stocks, bonds and funds in the right proportions is a delicate balancing act. Once you’ve selected those asset allocations, the common wisdom is to rebalance your investments periodically back to their original proportions to contain risk and possibly improve returns.
But is rebalancing your investments really necessary? The answer may surprise you.
Some experts like Alex Stimpson, co-chief investment officer at Corient Capital Partners, equate rebalancing with wealth preservation. “In bull markets, rebalancing is a fancy term for profit-taking, and it makes perfect sense to do so,” he says. “Investors appreciate the fact they can lock in some portfolio gains while taking meaningful risk off the table. That’s wealth preservation properly executed.”
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At the other end of the spectrum is the founder of index fund powerhouse Vanguard Investments John Bogle. In a CNBC interview, Bogle said he never rebalances his investments. If you can stomach the additional risk, never rebalancing can increase annual returns from 8.1 percent to 8.9 percent. But this gain comes with a volatility surge. By one risk measure — standard deviation — volatility increased from 10.1 percent for the rebalanced portfolio to 13.2 percent for the never rebalanced portfolio, according to a Vanguard report, “Best Practices for Rebalancing.”
While it’s important to review your investments on a regular basis, making changes to your portfolio to rebalance is not always necessary and ultimately depends on your age, goals, income needs and comfort with risk. In fact, sometimes rebalancing may do more harm than good, especially if done too often.
Rebalancing is not an appointment on your calendar. Some experts recommend rebalancing at regular intervals such as quarterly or annually, but this time-based approach risks making rebalancing something you should do at a set date no matter what.
A better strategy may be to set percentage limits on how far your portfolio’s asset allocations can stray from their original targets. Going past those boundaries then becomes your cue to rebalance. So, for example, a 5 percent limit for a large-cap stock allocation of 20 percent means that whenever the percentage drifts 5 percent on either end, you should rebalance back to your original 20 percent target. If large-cap stocks have a good year and become 25 percent of your total investments, sell 5 percent to restore the correct allocation. The same principle applies to buying more large caps if they drop in value and become 15 percent or less of your total investments.
Joseph Inskeep, a certified financial planner at Advanced Wealth Strategies Group, offers a third strategy for when to rebalance, that of tactically freeing up cash so that you can snap up bargains if the market drops. He recommends rebalancing annually to maintain a 20 percent cash allocation that can be deployed whenever deep discounts appear.
The costs may be more than the benefits. Whichever strategy you choose, keep in mind that frequent rebalancing costs money that can squander returns. “A $49.95 transaction cost to rebalance $1,000 from stocks to bonds is expensive and may be an avoidable 5 percent fee,” says Dejan Ilijevski, president of Sabela Capital Markets.
Besides the transaction costs, trading in and out of markets too frequently can produce disappointing returns. In fact, “the more frequently an investor rebalances a portfolio, the more they begin to engage in market timing,” Ilijevski says.
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In a taxable account, rebalancing could produce capital gains that might goose your tax bill. If rebalancing triggers a capital gain and you don’t have the cash on hand to pay the tax, you might want to avoid rebalancing, says Louis Wolkenstein, managing principal at the Investment Advisor. “You must gauge the long-term benefit of rebalancing versus the short-term consequence of rebalancing,” Wolkenstein says.
Some alternative investments, annuities and limited partnerships shouldn’t be traded when rebalancing because they aren’t easily converted to cash and may require a lockup period, with substantial costs for trading.
You may end up watering weeds instead of pulling them. When one or more investments are on a roll, rebalancing can rob your portfolio of that momentum. “There is much buzz about the importance of rebalancing, where you systematically trim positions that have appreciated and add to positions that have withered to arrive at the original percentage portfolio allocation,” says Dan Stewart, president and CIO of Revere Asset Management. “The problem is many times this is picking the flowers to water the weeds.”
If an investment class is expected to continue growing, you might want to delay your rebalancing schedule and get the benefit of that growth instead. Just don’t mistake this flexibility as a reason to ignore your portfolio altogether. In an ever-changing market, an investment review process is vital, Stewart says.
Retirees need a distinct rebalancing plan. How and when to rebalance will vary based on your life stage.
As you get older, not rebalancing may lead you to take on more risk than you realize, and if the worst happens, you won’t have time to recover those losses. “Many retirees may be vulnerable to sudden market corrections and volatility, which can adversely impact savings,” says Tom Foster, MassMutual’s practice management leader for retirement plans.
A recent MassMutual Retirement Savings Risk Study found that even though investors had planned to shift to more conservative allocations as retirement neared, many continued to invest aggressively when that time came. Those who dialed down their risk often did so because a financial advisor prompted them to. Of the survey respondents who had consulted with an advisor, 73 percent of pre-retirees and 88 percent of retirees said their advisor recommended that they invest more conservatively.
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John H. Robinson, founder of Financial Planning Hawaii, has an unusual strategy that flies in the face of this advice so that retirees don’t run the risk of outliving their savings. He suggests withdrawing savings from bonds first in retirement, which has the effect of tilting a retired investor’s portfolio toward stocks over time. That strategy, he says, “is most apt to leave a larger remaining balance at the end of 30 years, while rebalancing [to a more conservative allocation] leaves the smallest amount.”
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Is Portfolio Rebalancing Necessary? originally appeared on usnews.com
