By Dan Hallett on April 13, 2020
Rebalancing an investment portfolio involves occasionally selling better recent performing investments to buy more of those investments that have performed poorly. This usually happens during bear markets for stocks (i.e. when prices drop by at least 20%). And as I wrote last summer; when you rebalance, you assume that big moves in prices will eventually reverse (i.e. mean reversion). We now find ourselves in the bear market for stocks that many knew was inevitable (though nobody knew the timing or trigger). With stock indexes down 25% to 40% (some individual stocks may be down a lot more); it’s time for a reminder of why and when to rebalance.
In recent weeks, I saw many references on Twitter (where I am reasonably active) to the effect of “now is the time to rebalance”. Some of those statements gave me the impression that people were trying to call a bear market bottom. That should never be the basis for rebalancing because it’s not really a market-timing tool – even though it can sometimes result in well-timed trades.
We spent a lot time researching, reading, and thinking about rebalancing. And we designed our strategy with circumstances just like this in mind – not pandemics per se but really bad economic environments when stocks are falling and when it feels like the world is crumbling around us (even though it’s not). This was the case 2008. The idea was to have a well-researched, thoughtful approach that would allow us to rely on the rigor of our work rather than fear or gut instinct.
So far, we have rebalanced a handful of our clients’ portfolios. Why so few?
Because our decision to rebalance is never based on our view of the market and when we think the tide will turn. Rather, rebalancing is based on where each client’s portfolio sits relative to their target allocations (which in turn are based on generating the target return in each client’s wealth plan while adhering to each client’s tolerance for risk). Given that the losses so far are about average by historical bear market standards; most portfolios have not yet breached the minimum threshold for their allocation to stocks (or maximum for bonds & cash). But if losses deepen – say to 40% or worse – before a recovery takes hold; it’s likely that most clients – if not all – will get triggered for rebalancing.
I have often spoken of investment success not in the context of certainties but in doing what we can – as fiduciaries – to tilt the investing odds in our clients’ favour. This involves, in part, influencing good investor behaviour. In the case of rebalancing we address this structurally – by having clients give us authority to take action – like rebalancing – on their behalf when first becoming clients. Looking back to 2008, my study of mutual fund flows suggests that individual investors – including most with an advisor – did not rebalance.
The reason is that it’s very tough to jump on a train that is going down quickly. Even tougher when selling the only investments that are making money at the time. To their credit, most investors didn’t panic-sell but nor did they rebalance – generally speaking. And in most cases, advisors need clients’ permission before executing a rebalance – and they have to do it one client at a time. So having the ability to act on our clients’ behalf is key to making sure portfolios are rebalanced when needed. And that’s one of the many things we aim to do to tilt the odds in our clients’ favour to increase their chances of long-term success.