Finding balance in stormy seas
Of all the generally accepted investment concepts called into question by the recent market environment, it seems to me that rebalancing is pretty close to the top of the list.
During late 2008 and early 2009, rebalancing your portfolio to stay close to your asset allocation target would have been almost a daily ritual—and one that would have felt increasingly futile. Even if you’d stuck to an annual approach, closing the gap between your actual asset allocation and your target would have required strong nerves.
Nevertheless, rebalancing remains an essential portfolio management tool. It does, however, require faith in another concept that’s been under fire: asset allocation. In order to rebalance, an investor must know the asset allocation to which he or she is rebalancing. Rebalancing is simply a means to that end. As such, an investor should reassess whether they’re rebalancing to the right target for them before moving any money around.
This is a good time to take a hard look at that allocation and ask questions such as, “Was I really too aggressive for what I was trying to do?” or “Was I truly diversified?” Granted, even portfolios that were diversified (stocks/bonds/cash) took a hit last year—but the damage they suffered was far less than that of portfolios that weren’t. So, let’s continue to accept the merits of rebalancing.
That said, I think there are ways to approach rebalancing so that it doesn’t feel like having to get across the Grand Canyon in a single leap. For example, you might decide to rebalance over a six-month period. Let’s say your target is a 50-50 split between stocks and bonds, and your current allocation is 38% stocks/62% bonds. You might take the 12-percentage-point gap and divide by six. The result: Each month for six months, you’d shift your allocation 2 percentage points closer to your target.
If you’re participating in a 401(k) plan, one way to do this over time would be to redirect contributions to the underrepresented asset class. There may also be “windfalls” in your future: a bonus at work, overtime pay, or the sale of other assets. If you’re retired, you could redirect fund distributions (e.g., dividends) to a fund that will help you get back to your target.*
Of course, rebalancing to your target asset allocation does just that, and no more. It’s not meant to increase your account balance. For that, you might need to save more—or get little cooperation from the markets!
A combination of both would seem to be a good compromise.
* If you’re in retirement, this Vanguard.com article may shed some light on how rebalancing can keep you on course.
Notes:
- All investments are subject to risks. Investments in bonds are subject to interest rate, credit, and inflation risk.
- Diversification does not ensure a profit or protect against a loss in a declining market.
I set an asset allocation target that I am comfortable with but I don’t know that it is exactly the right one. So I don’t rebalance unless the current balance is significantly out of kilter. Minor imbalances are not seen as a problem and Vanguard probably does not like or tolerate a lot of transferring from one account to another.
A problem with balancing within a 401k and 403b is (i) the hassle of changing the paperwork, (ii) the long dwell between when the cash is removed from your paycheck and it actually lands in the account (can be weeks). One problem of rebalancing is the wash rule + Vanguard’s 2-month policy. I recall a Vanguard report (meant for institutional investors) that indicated that, in times of high market turbulance, very fast rebalancing — a kind of ratcheting by selling high and buying low– is actually beneficial. But this would have to be done with ETFs, correct? The problem really is when to rebalance, i.e. at what percentage deviation does it make sense to rebalance. Barring use of ETFs I could be convinced that rebalancing at 2-3 month intervals might make some sense. The idea here is to survive financially and possibly make some money, not adhere blindly to a philosophy.
As a conservative, buy and hold investor I find your articles right on and informative even in retirement. Keep it coming.
Rebalancing is my focus now but some general trends can be discerned especially in your allocation of stocks vs, bonds. With the expectation that the market will recover and the excessive spending and borrowing being done by all world governments. It could be bond yields may be the next nemesis. Owing bonds is no sure bet, ask GM bond owners.
Why does Vanguard not have a feature where an individual selects his desired asset allocation in a 401k and (ie 50% total stock market, 50% total bond market) the Vanguard computers rebalance it automatically similar to a target date fund?
yeh right.. great post, Thank You
Just getting around to reading this and I agree with the Aug. 15, 2009 post as to why Vanguard doesn’t offer a feature of automatically reblancing if the client agrees to it. Was that ever answered?
Agree with Aug 8, 2010. Do you plan to add such a feature to aid in rebalancng? If not, please post a ‘how to’ for rebalancng on this website.
Thanks