Rebalance to overcome your investment biases
The bull market in stocks has been running for nearly 81⁄
2 years – one of the longest upward stretches ever. Have you rebalanced your portfolio lately to account for that?
You might want to think about rebalancing to lower your risk and possibly improve performance. This buy-low, sell-high approach can help you stick to a plan and overcome harmful psychological tendencies. “Consistent rebalancing is a reliable, and often underappreciated, source of higher riskadjusted performance for the patient investor,” Brent Leadbetter and two colleagues at investment-firm Research Affiliates wrote recently.
It can help investors overcome the natural tendency to wait and see before tweaking their investment mix.
How rebalancing works
It’s a fairly simple concept: With rebalancing, you occasionally want to cash in some profits on high-flying stocks or other assets, then reinvest the proceeds in laggards. The idea is to bring your overall portfolio back in line with a long-term mix that’s suitable for you. Rebalancing assumes you have a target mix of stocks, bonds, cash and other investments and want to stick with it.
Suppose you decided that a split of 60 percent stocks/stock funds and 40 percent bonds/ bond funds is a good mix. If you’re currently sitting at 65 percent/35 percent, for example, you might want to pull assets equal to five percentage points from stocks and reinvest them in bonds, to get back to that 60/40 position.
Stock prices have tripled since the long bull market be- gan in March 2009. Consequently, you might have a bit too much in stocks, especially as you’re older now and presumably want a less-volatile portfolio.
“The biggest advantage of rebalancing is that it helps you manage risk,” said David Fernandez, a certified financial planner at Wealth Engineering in Scottsdale, Arizona. “The U.S. stock market has done so well lately that, if you’re not rebalancing, you’ll wind up with a portfolio that’s heavily concentrated in (large) U.S. stocks.”
Behavioral issues
A less-obvious aspect to rebalancing is that it can help investors overcome psychological tendencies that can prove harmful.
Greed is one. As explained by the Research Affiliates report, when investors are sitting on large paper profits in the stock market, they could become susceptible to the “house money” effect. This explains the tendency of casino gamblers on a winning streak to stay too long at the table. So too with many investors.
Fear of missing out is another. Many of us tend to remain heavily invested in stocks even when it becomes risky to do so, out of fear that our friends will brag about all the money they’re making if the market keeps rising.
These behaviors are easier to overcome if we stick to a plan. Rebalancing provides a discipline for taking such actions even when they don’t feel right. Conversely, rebalancing also provides the justification for keeping at least a toehold in the stock market at all times. It can help you view bear markets not as cycles to be feared but as buying opportunities.
Tips for success
Rebalancing is a simple concept, but there are ways to make it more effective. Here are some tips on that:
❚ Rebalancing works best inside Individual Retirement Accounts, 401(k) plans and other accounts where buy/sell decisions don’t trigger taxable gains or losses. If it would exert a tax impact or cause big trading costs, you might want to rebalance less frequently.
❚ You don’t need to rebalance all that often. Many advisers suggest doing so about once a year or after your portfolio has drifted out of whack by maybe five percentage points.
❚ Rather than selling assets to rebalance, an alternative would be to earmark new investment dollars or reinvested dividends into stocks or bonds that have lagged.
❚ Rebalancing doesn’t work as well with individual stocks or bonds, which conceivably could lose all their value. You want to use broadly diversified funds.
As noted, the flip side to rebalancing is that it can slow your gains during periods of sustained rising prices. But after more than eight years of a mostly upward trend, the odds are increasing for a major downward shift.