Portfolio Rebalancing – Balancing Risk and Return

Portfolio Rebalancing - Balancing Risk and Return

We are all familiar with the old adage that to be a successful investor you must buy low and sell high. I’m not sure anyone would argue this fact but unfortunately for most people this is a rather elusive concept. Why?

Portfolio rebalancing is a time tested investment technique that is primarily a compilation of a couple of simple investment concepts. The concepts are investing in a manner that is consistent with your personal tolerance for risk and “buy low and sell high”. We have all heard this on countless occasions so let’s talk about how portfolio rebalancing can aid investors in maintaining an investment portfolio that suits their individual risk tolerance. We will also look at why the individual investor has not been successful in effectively doing this.

Risk Tolerance

When we think of risk tolerance we should think of how far down our portfolio can fall in value before we hit the panic button and sell. I like to personally call it the investor’s threshold for pain. One of the variables with the greatest impact on the volatility on a portfolio is the ratio of stocks to bonds. Generally speaking, the greater the amount of stocks in a portfolio the farther the portfolio can fall in value and vice versa.

Let’s start with the premise that an investor’s tolerance for risk suggests an investment portfolio with ratio of stocks to bonds equal to 50-50. If the stock market has a banner year and increases by 20% while the bond market loses 5%, this portfolio now consists of a ratio of about 62% stocks and 38% bonds which is now quite a bit above the investor’s threshold for risk. Over long periods of time, the asset allocation of your investment portfolio would continue to diverge from the ideal stock to bond ratio. Rebalancing would entail selling enough of the stock portion of the portfolio and subsequently using the proceeds to buy into the bond portion of the portfolio to get back to the 50-50 ratio we began with and in line with the investors risk tolerance.

Buy Low and Sell High

Now let’s look at the second concept of buying low and selling high. This is an easy concept to understand since it is fundamental to why we invest in the first place. After all who would want to buy high and sell low? (Surprisingly there are many who do so but I’ll save the reasons why that happens in another post).

Let’s continue with our last example where the stock portion of the portfolio was up 20% while the bond portfolio was down 5%. We know that stocks won’t go up forever nor will bonds go down forever and that at some point bonds will outperform stocks in a given year. Rebalancing is a systematic way of selling some of the stock portfolio while it is high (selling high) and use the proceeds to buy more shares in the bond portfolio while it is low (buying low).

As you can see portfolio rebalancing can be very helpful in a couple of ways but surprisingly few individual investors rebalance even when they may be aware that they should. And the reason, not surprisingly, is for the same reason that individual investors fall short on a number of other fronts as well – human emotion.

Portfolio rebalancing can be an emotionally charged situation. It is extremely difficult for most individual investors to get rid of or reduce the position of an investment that has done well. For some reason our general thought process seems to tell us that winners keep winning and losers keep losing. This can be true in many other walks of life but not when it comes to investing (provided of course that you have a fully diversified portfolio to begin with).

How we keep investment portfolios balanced

At this point you may be thinking at that I used a very simple example to illustrate my point and that perhaps it is possible that the logic behind portfolio rebalancing falls short when a portfolio becomes more complex. This is a very fair question because in reality a well-diversified portfolio will consist of potentially dozens of distinct asset classes. When it comes to your investment portfolio, it doesn’t matter – rebalancing works regardless of the number of distinct asset classes that may be present.

As a professional portfolio manager, I utilize portfolio rebalancing techniques on a regular basis. If you manage your own investment portfolio, I strongly suggest that you consider using this technique as well. However, most investors who manage their own portfolios do not have the proper tools or emotional discipline to implement a portfolio rebalancing strategy. If you have a difficult time selling the winners and buying the losers, it may be a good strategy to hire a professional money manager to make those difficult rebalancing decisions.

If you want more on portfolio rebalancing, listen to the following excerpt from the Financial Spotlight radio show: