Oct 30, 2024 | 5 min read
You've probably heard that you should "set it and forget it" when it comes to investing. While there's some truth to this – constant tinkering can be counterproductive – there's one key strategy that can make a big difference in your long-term returns: rebalancing.
What is Rebalancing?
Rebalancing is the process of periodically adjusting your portfolio back to its target asset allocation. Let's say you start with a 60% stocks / 40% bonds portfolio. Over time, as stocks typically grow faster than bonds, your portfolio might drift to 70% stocks / 30% bonds or even more.
Take a look at this chart:
Equity allocation of 60% stock/40% bond portfolio, rebalanced and non-rebalanced, 1960 through 2021
Notes: Stocks are represented by the Standard & Poor’s 500 Index from 1960 to 1974; the Wilshire 5000 Index from 1975 to April 22, 2005; the MSCI US Broad Market Index from April 23, 2005, through June 2, 2013; and the CRSP US Total Market Index thereafter. Bonds are represented by the S&P High Grade Corporate Index from 1960 through 1968; the Citigroup High Grade Index from 1969 through 1972; the Bloomberg U.S. Long Credit AA Bond Index from 1973 through 1975; the Bloomberg U.S. Aggregate Bond Index from 1976 through 2009; and the Bloomberg U.S. Aggregate Float Adjusted Index thereafter. Data are through December 31, 2021. Source: Vanguard calculations based on data from FactSet
This graph shows what happens to a 60/40 portfolio over time if it's not rebalanced. The blue line, representing the non-rebalanced portfolio, drifts upward, becoming more heavily weighted towards stocks. The orange line, representing the rebalanced portfolio, stays steady at 60% stocks.
Why Rebalancing Matters
You might be thinking, "If stocks generally perform better over time, why not let my portfolio become more stock-heavy?" Great question! There are a few key reasons:
Risk Management As your portfolio becomes more stock-heavy, it also becomes riskier. This might be fine when you're young, but as you get closer to your financial goals, you might want to reduce risk.
Buying Low and Selling High Rebalancing forces you to sell some of your winners (selling high) and buy more of your underperforming assets (buying low). This is a systematic way to capitalize on market movements.
Sticking to Your Plan Your initial asset allocation was chosen based on your goals and risk tolerance. Rebalancing helps ensure you stay on track with your original plan.
The Impact of Rebalancing
Let's look at some data to see how rebalancing affects returns and risk:
Notes: Stocks are represented by the Standard & Poor’s 500 Index from 1960 to 1974; the Wilshire 5000 Index from 1975 to April 22, 2005; the MSCI US Broad Market Index from April 23, 2005, through June 2, 2013; and the CRSP US Total Market Index thereafter. Bonds are represented by the S&P High Grade Corporate Index from 1960 through 1968; the Citigroup High Grade Index from 1969 through 1972; the Bloomberg U.S. Long Credit AA Bond Index from 1973 through 1975; the Bloomberg U.S. Aggregate Bond Index from 1976 through 2009; and the Bloomberg U.S. Aggregate Float Adjusted Index thereafter. The risk-free rate used in the Sharpe ratio calculation is the U.S. cash reserve return, using the Ibbotson U.S 30-Day Treasury Bill Index from 1960 to 1977, and the FTSE 3-Month U.S. T-Bill Index thereafter. Source: Vanguard calculations based on data from FactSet
This table compares three portfolio strategies:
A 60/40 portfolio that's regularly rebalanced
A 60/40 portfolio that's allowed to drift
An 80/20 portfolio that's regularly rebalanced
Here's what we can learn:
Returns The drifting 60/40 portfolio actually had higher returns (9.88%) than the rebalanced one (9.23%). This makes sense, as it ended up with more stocks over time.
Risk However, the drifting portfolio also had much higher risk, with a standard deviation of 13.81% compared to 11.00% for the rebalanced portfolio.
Risk-Adjusted Returns The Sharpe ratio, which measures risk-adjusted returns, is highest for the rebalanced 60/40 portfolio at 0.43. This means it provided the best returns relative to its risk.
Comparison to 80/20 Interestingly, the drifting 60/40 portfolio ended up with similar risk to a rebalanced 80/20 portfolio, but with slightly lower returns.
The Volatility Factor Let's look at one more chart:
Notes: Stocks are represented by the Standard & Poor’s 500 Index from 1969 to 1974; the Wilshire 5000 Index from 1975 to April 22, 2005; the MSCI US Broad Market Index from April 23, 2005, through June 2, 2013; and the CRSP US Total Market Index thereafter. Bonds are represented by the S&P High Grade Corporate Index from 1960 through 1968; the Citigroup High Grade Index from 1969 through 1972; the Bloomberg U.S. Long Credit AA Bond Index from 1973 through 1975; the Bloomberg U.S. Aggregate Bond Index from 1976 through 2009; and the Bloomberg U.S. Aggregate Float Adjusted Index thereafter. Source: Vanguard calculations based on data from FactSet
This graph shows the 10-year rolling volatility for different portfolio strategies. Notice how the rebalanced 60/40 portfolio (orange line) consistently has the lowest volatility. The drifting 60/40 portfolio (blue line) has volatility more similar to the 80/20 portfolio (grey line).
What This Means for Young Investors
As a young professional, you might be tempted to go for the highest returns possible. After all, you have time to ride out market volatility, right? While there's some truth to this, consider the following:
Peace of Mind Lower volatility can help you stick to your investment plan during market turbulence. The best investment strategy is one you can actually stick with.
Flexibility Life can be unpredictable. A lower-volatility portfolio gives you more flexibility if you need to access your money earlier than planned.
Compound Growth Remember, steady returns can often outperform higher but more volatile returns over time, thanks to the power of compounding.
Automatic Discipline Rebalancing provides a systematic way to "buy low and sell high" without trying to time the market.
How to Implement Rebalancing
Set a Schedule Rebalance annually or semi-annually. Avoid doing it too frequently, as this can increase costs.
Use Thresholds Alternatively, rebalance when your allocation drifts by a certain percentage (e.g., 5% from your target).
Use Cash Flows If you're regularly contributing to your investments, use new contributions to rebalance by buying underweight assets.
Consider Tax Implications In taxable accounts, be mindful of potential capital gains taxes when rebalancing.
Final Thoughts
Rebalancing might not be the most exciting part of investing, but it's a powerful tool for managing risk and potentially improving your long-term, risk-adjusted returns. It adds discipline to your investment strategy and helps ensure that your portfolio stays aligned with your goals and risk tolerance.
While Vanguard's research suggests that rebalancing can add about 0.14% to your annual returns, its true value lies in risk management and helping you stick to your investment plan through market ups and downs.
For young professionals, starting with a solid investment plan and consistently rebalancing can set you up for long-term financial success. It's a simple yet effective way to stay on track with your financial goals, no matter what the market throws your way.
For a more comprehensive look at how financial advisors can add value through rebalancing and other strategies, check out our in-depth blog post: "The Hidden Value of Financial Advisors: More Than Just Investment Returns."
At Israilov Financial, we recognize the importance of maintaining a balanced portfolio that aligns with your risk tolerance and financial goals. We implement disciplined rebalancing strategies to help keep your investments on track, potentially improving returns while managing risk. If you're interested in learning how we can help optimize your portfolio through strategic rebalancing, schedule your free discovery meeting.
IMPORTANT DISCLAIMERS
Past performance is no guarantee of future returns
The graphs and charts in this commentary are for illustrative purposes only and not indicative of any actual investment. Index returns do not reflect any fees, expenses, or sales charges. It is not possible to invest directly in an index. Stocks are not guaranteed and have been more volatile than other asset classes. Historical returns were the result of certain market factors and events which may not be repeated in the future. Financial professionals are responsible for evaluating investment risks independently and for exercising independent judgement in determining whether investments are appropriate for clients.
This material is intended for information purposes only, and does not constitute investment advice, a recommendation or an offer or solicitation to purchase or sell any securities.
Disclaimer: Investments are not guaranteed and are subject to investment risk, including possible loss of the principal amount invested. Past performance is no guarantee of future results. All allocations and opinions expressed are as of the date of this presentation and subject to change. The information contained herein does not constitute investment advice or a solicitation. Information obtained from 3rd parties is believed to be accurate, but has not been independently verified.
The opinions expressed in this article are for general informational purposes only and are not intended to provide specific advice or recommendations for any individual or on any specific security. The material is presented solely for information purposes and has been gathered from sources believed to be reliable, however Israilov Financial LLC cannot guarantee the accuracy or completeness of such information, and certain information presented here may have been condensed or summarized from its original source. Israilov Financial LLC does not provide tax or legal advice, and nothing contained in these materials should be taken as such.
As always, please remember investing involves risk and possible loss of principal capital. Advisory services are only offered to clients or prospective clients where Israilov Financial LLC and its representatives are properly licensed or exempt from licensure. No advice may be rendered by Israilov Financial LLC unless a client service agreement is in place.
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