Depending on your age, Halloween conjures many images—some sweet, some scary. My girls are young and seem to experience both extremes: They love the treats but could do without some of the scarier imagery. As adults and investors, we’re not immune to the sweet and scary, and as much as we love to see our portfolios grow over time, we must occasionally face our own fear: rebalaphobia1, or the fear of rebalancing.
Recent returns in the global equity markets have been tremendous. For the five years ended September 30, 2014, global equities gained a cumulative 97.2%, while global bonds gained 26.0%*. Although both asset classes posted sweet returns, the very large difference in returns resulted in a meaningful increase in the equity holdings in many people’s portfolios. For example, Figure 1 shows a globally diversified portfolio of 60% stocks and 40% bonds² established at the beginning of 2009. Thanks to the stock market’s gains following the recovery that began that March, by year-end equities made up 65% of the portfolio. That’s a pretty significant increase in equities, given their historical volatility. Based on our rebalancing research, we feel that most investors should review their portfolio annually and rebalance if an asset class’s weight is 5 percentage points or more out of line with the original, strategic asset allocation.
* Global equities are represented by 70% Spliced Total Stock Market Index and 30% Spliced Total International Stock Index. Global fixed income is represented by Barclays US Aggregate Float Adjusted Index through January 31, 2013, and 80% Barclays US Aggregate Float Adjusted Index and 20% Barclays Global Aggregate ex-USD Float Adjusted RIC Capped Index (USD Hedged) thereafter. Spliced Total Stock Market Index is represented by MSCI US Broad Market Index through June 2, 2013, and CRSP US Total Market Index thereafter. Spliced Total International Stock Index is represented by MSCI EAFE + Emerging Markets Index through December 15, 2010, MSCI ACWI ex USA IMI Index through June 2, 2013, and FTSE Global All Cap ex US Index thereafter.
Historically, a 60/40 portfolio like this would have required rebalancing about every four years using this “5% rule.” It really doesn’t require much time or even attention to rebalance. So why the phobia? Given the return patterns I mentioned above, the need to rebalance typically occurs when stocks have dramatically outperformed bonds and we fear they might continue to do so. Rebalancing ‘too early’ means leaving some gains on the table. It also means that we’d need to add to our bond allocation using the proceeds from our stock sales. I don’t know if you’ve heard, but at today’s yields, bonds aren’t necessarily the most popular asset class around.
So, rebalaphobia is a common problem for investors, who often dislike selling their better-performing assets to buy more of what hasn’t done well in their portfolios. On the surface, this fear seems reasonable, because the future is uncertain and the outperformers in the portfolio could continue to outperform. This is, however, far from a foregone conclusion. The truth is that there never is a perfect time to rebalance when you use higher returns as your measuring stick for success. Rebalancing is important, same as it ever was, but it is a discipline designed to manage risk rather than maximize return.
As we move toward the end of 2014 with the stock markets at historically high levels, the choice to rebalance—at least for some people—may still seem frightening. To be honest, I often feel the same way, and I think that’s just human nature. As Figure 1 also illustrates, while equity allocations drifted to high enough levels in 2009 and 2013 to warrant rebalancing the portfolio, the equity markets didn’t dramatically sell off thereafter. We all fear making the wrong decision, and overcoming rebalaphobia is often as much an emotional challenge as it is an investment decision. However, on one decision I can feel 100% confident: Until the future is certain, diversification, asset allocation, and rebalancing will be the cornerstones of my portfolio.
I would like to thank my colleague, Donald Bennyhoff, for his contribution to this blog.
¹Of course, rebalaphobia is not a medically recognized affliction, but we’re working hard to change this obvious oversight.
²This illustration is for a globally diversified 60/40 portfolio. Non-U.S. equities were given a weight of 30% total equities, with non-U.S. bonds making up 20% of the total fixed income allocation.
Please remember that all investments involve some risk. Be aware that fluctuations in the financial markets and other factors may cause declines in the value of your account. There is no guarantee that any particular asset allocation or mix of funds will meet your investment objectives or provide you with a given level of income.