A Vital, But Under-Used Portfolio Strategy

An important (but very underutilized strategy) for investors is to periodically rebalance their investment portfolios.  Rebalancing means shifting assets within a portfolio so that the portfolio’s asset allocation is returned to its original target weights.

For example, say a portfolio’s target allocation is 60% equities and 40% bonds.  After a year of strong stock performance, the portfolio now holds 65% equities and 35% bonds.  Rebalancing would be to simply sell 5 percentage points worth of equities and buy 5 percentage points of bonds in order to return to the 60/40 target.

Rebalancing accomplishes two important things for an investor.

  • First, it systematically forces an investor to “buy low, sell high.”  While this sounds easy to do in theory, in fact many investors have a very difficult time selling what has recently done well to buy something that has not done as well.  In fact, research shows that many investors do the opposite: this is, they buy more of what has recently done well—whether we’re talking about funds or individual securities.  Buying good assets when they have become relatively cheaper is a good investment strategy.
  • Second, rebalancing serves to reduce portfolio risk.  Without rebalancing, what can happen—and what did happen to many tech investors in the late 1990s and many real estate investors in the mid-2000s—is that they ended up with too much wealth concentrated in just the wrong sector at just the wrong time and were very exposed to the downturn.  A portfolio that is being rebalance periodically may not go up as fast as a portfolio concentrated in a hot sector or industry, but nor will it fall as hard in a downturn.  In money management, it is more important not to go down than it is to go up.

The mechanics of rebalancing plan are not really that complicated.  What makes rebalancing difficult for investors to execute is that it is emotionally difficult to sell something that has done well in order to buy something that has not done as well.  By basing your rebalancing plan on quantitative parameters, however, you are more likely to 1) have better and steadier investment returns over time and 2) less stress in your life.

In my view, having a portfolio rebalancing plan is particularly important today.   Both stocks and bonds are trading at rich valuations and it would not be surprising to see returns over the next decade or so fall below their long-term averages.  Thus it will be important for investors to take advantage of the opportunities they will have in volatile markets to ‘buy low’ and ‘sell high’ among the different asset classes in their portfolios.

To learn more about how we manage client portfolios, please visit us at www.orionportfolios.com


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