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I fear rebalancing has been oversold—and that I was one of the overeager salespeople.
Rebalancing is primarily a risk-control strategy. As financial markets rise and fall, we may find we have more than our target portfolio percentage in large-cap growth shares, or emerging markets, or stocks generally. Rebalancing back to our portfolio targets trims our exposure, reducing the risk of a big financial hit if there’s a reversal in the market’s recent rise.
But rebalancing is also pitched as a way to boost returns. The notion: We should have portfolio targets for value and growth stocks, and large-cap and small-cap shares, and U.S. stocks, developed foreign markets and emerging markets. If, say, value stocks sprint ahead of growth stocks, we should rebalance back to our portfolio targets, potentially selling high and buying low.
Two decades ago, this struck me as a smart and easy way to boost returns. I was wrong. The problem: Market trends often persist for far longer than imagined. If you rebalance among market sectors every year or two, there’s a good chance this attempt to boost performance will achieve just the opposite, capping returns by choking off our exposure to a major market trend that still has many years to run.
We don’t have to look far to find examples of trends that lasted far longer than most investors expected. Emerging-market stocks had a long stretch of sparkling gains in this century’s first decade. That was followed by 15 years of stellar results from large-cap U.S. growth stocks. Rebalancing back to a portfolio’s target sector weightings would have limited these gains—what some would call cutting the flowers and watering the weeds.
To be sure, it would be great to shift from large-cap to small-cap stocks just as the market’s winds were shifting. But I’m not smart enough to succeed at that sort of market-timing, and I’m not sure anybody is.
What to do? My advice: Don’t rebalance among stock-market sectors and among bond-market sectors. The good news is, those of us who favor total-market index funds already avoid this sort of rebalancing. We never fiddle with, say, our mix of growth and value shares, instead letting our portfolio’s allocation change along with the market.
That doesn’t mean we should throw out the notion of rebalancing. I think it’s important occasionally to rebalance between stocks and more conservative investments, thereby keeping a portfolio’s risk level under control. Without that sort of rebalancing, an investment mix would likely become increasingly risky, as stocks grew to be an ever-larger portion of the portfolio.
For those with a contrarian bent, I’d also put in a plug for over-rebalancing during major stock-market declines. The notion: Overweight stocks when they’re deeply underwater. This is something I did during 2007-09, 2020 and 2022. But make sure this overweighting is temporary. As the stock market recovers, look to move back to your target stock percentage, so you don’t leave yourself vulnerable to a big stock-market decline.
In April I rebalanced funds in TIAA/CREF (educator/academic here) from US growth index (QCGRIX) to international growth (QCGLIX). This was motivated in large part by Jonathan’s posts on the value of a diversified global approach. No regrets so far. Lowered stress actually, if that can be quantified. Thank you Jonathan.
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Rebalancing, I made the ultimate changes from 60/40 to 70% S&P, 15% QQQ and 15% cash about 5 years ago. From 50 stocks to 2 main ones, and cash to tide me over the down times. In my 56 years of saving there have only been 9 down years, however it was a tough time in 2000, 2001 and 2002 my investments crashed 45% over those 3 years, however I hung tough, sold nothing, and it recovered by the end of 2004. As an Electronic Engineer, I am a BIG believer in Tech and AI. At 79, I have no fear of the market. I just cannot stand bonds, the ballast never worked for me.
I have a strong stomach for market declines, like you, and also worked in technology. I don’t know your situation, goals for investments, needs, income sources, etc. But if you rely on investments for any essential expenses, and investments are not for legacy alone, here are three questions to ponder, with some context:
Except for a relatively small and brief dip in 2022, we’ve had a strong bull market in stocks these last five years since March 2020. Valuations by some measures are now stretched higher than in 2000.
Q1: Will you be financially OK today if SPY and QQQ drop 50% or more and take 7-10 years to recover?
Today, there is a lot of overlap with intense top-20 concentration between SPY and QQQ. With the allocation you mentioned, 30% of your whole portfolio is in nine tech giants (Apple, Microsoft, Nvidia, Amazon, Google, Meta, Tesla, Broadcom) plus Pepsi.
Q2: Ever thought of replacing SPY+QQQ with say Vanguard’s VT, which gives broader U.S. stock ownership, still holds plenty of tech in its top-10, but adds some ex-US exposure where valuations are less-stretched?
Long bonds do suck as ballast, especially if the term premium is near zero as it was in 2022. If it’s solid ballast you seek, look no further than T-bills.
Q3: If your 15% cash isn’t enough to cover 7-10 years of whatever expenses you pay out of your investments, could you live with adding a slice of say 3-month T-bills to the mix?
No need to reply, silence is a fine answer. Best wishes, -D
Why no international?
I find lately that most of the rebalancing I do is directing distributions (not automatically reinvested) to the asset classes that are the most under my target allocation.
Risk fools us because we interpret the data selectively, but rebalancing is about gaining similar returns most of the time with less risk of sudden disaster.
Rebalancing can apply to many things. When it comes to bonds and stocks or their proxies, as with other balances, the problem may be that the original balance was not actually worth pursuing. Is my original balance actually worth maintaining? Why, exactly? I have previously written on Humble Dollar that I haven’t found bonds to be an attractive part of my investment mix.
But if you hold an index, you cannot easily rebalance within that index. The assumption is that the index is the balance. You could, of course, supplement that index, but that ruins the attractive simplicity–unless you use a contrary index. For example, an S&P 500 fund has over 4% of several high growth stocks. But none of those are in a typical dividend fund, so owning 25% of a dividend fund lowers the volatility of an S&P 500 fund (or total market fund, both capital weighted) essentially by 25%. I would consider this for anyone who owns an S&P fund in an attempt to avoid the volatility of individual stocks.
Regarding frequency of rebalancing, Shiller cites research that shows frequency is only limited by the hassle factor. In other words, while more frequent rebalancing is more efficient, the increase in frequency becomes progressively marginal in its utility. Part of this equation, then, becomes what I would otherwise be doing with that time.
I think what we do is aligned with the post both in practice and in principle. We rebalance on overall drift from our 60/40 stock bond asset allocation. We definitely do not tweak our individual holdings, where it be stock ETFs, REITs, commodity fund, bond ETFs or individual bonds and follow practices like 5/25. We both rebalanced and did a partial Roth conversion earlier this year when the market had a significant decline. We don’t bother trying to time it perfectly-we are happy to get a base hit without trying for a home run. With the stock market recovery I think we are currently back at around 62-63% stocks so just monitoring currently.
This is a timely post for me.
I never had to think about re-balancing because of my use of balanced and target date funds. My recent moves to consolidate most accounts, will soon have most of our funds in 3 ETFs, (domestic, international, and bond), so I will now have to deal with some basic re-balancing.