Our Approach to Rebalancing: A Case Study

As we mark the one-year anniversary of the pandemic-induced bear market, we want to shine a light on a major feature of our portfolio strategies that doesn’t often attract the spotlight: Rebalancing.

Studies demonstrate that rebalancing systems drive significant long-term value and March 2020 was a strong validation of concept, offering an excellent case study for how BEW rebalances client portfolios.

In this short video, Lead Advisor and CCO Ben Peters explores what rebalancing is and why it’s central to our portfolio strategy.

TRANSCRIPT

INTRO

·         Hi there, it’s March 23, 2021, the anniversary of the bottom of last year’s memorable bear market. In twelve months, we’ve transitioned from a scary and extremely uncertain climate to eyepopping exuberance - cryptocurrencies, digital artwork, cash offers hundreds of thousands over asking. And over the last year, the global stock market is up 80%!

·         As memories of last year’s bear fade, we thought we’d reflect a bit. If you were a fly on the wall of our offices last March, the top issue wasn’t forecasting the pandemic’s impact. First was making sure people stayed invested. Second, and the topic for today, was rebalancing client portfolios, a relatively nuts-and-boltsy topic.

·         While rebalancing may not be as exciting as Bitcoin or Gamestop, it is more central to our portfolio strategy than anything on the news. So, let’s dig a little bit into

1. What rebalancing is

2. Our approach

3. What happened last year

4. And why having a system is so vital.

Definition of Rebalancing

·         First, what is rebalancing? Every portfolio should aim toward a target risk profile, which is shorthand for an allocation to stocks and to bonds.

·         A portfolio that starts at target drifts as the markets tug at the investments. Rebalancing trades investments to bring the portfolio back to target. There are two goals:

1. Control the risk profile and

2. Capture buy-low / sell-high opportunities

·         Theoretically, we could trade every portfolio every day to optimize that first goal. But doing so would impair the second.

• Trading costs would mount.

• And markets have momentum – things that go up tend to continue to go up and vice versa. To rebalance daily would be to constantly sell winners and buy losers.  

·         The goal is to find a strategy that rebalances often … but not too often.

·         The most common approach to rebalancing is calendar-based, like in a 401(k). Regardless of what’s happening, on a set frequency, for example quarterly, overweight positions are sold and underweight positions purchased. But while straightforward, calendar-based systems are inefficient at buying low and selling high.

OUR APPROACH

·         A better approach is to build tolerance levels. This essentially sets a floor and ceiling, and rebalances when those limits are breached. Studies show optimal results with a 20% threshold. That’s not 20% of the whole portfolio, but 20% of the target. Here we have a 50% target. A threshold is triggered when the allocation rises above 60% or falls below 40%.  

LAST YEAR

·         Let’s bring this discussion to last March and use a $4 million portfolio for easy math.

·         Let’s say our target is 75% stock and 25% bonds, so $3 million in stocks and $1 million in bonds. The rebalance threshold is triggered when bonds exceed 30% and stocks fall below 70%.

• Last year, the stock market lost a third of its value, in weeks. $3 million of stocks turned into $2 million, a paper loss of $1 million. Quite harrowing stuff.

• For simplicity’s sake, let’s say bonds stay even. The $1 million in bonds are now a third of the $3 million portfolio.

• A 75% target would allocate $2 and a quarter million to stocks. So, our rebalancing system compels us to sell $250,000 in bonds and buy $250,000 in stocks.

• Now since March 17, 2020, stocks are up about 65% and bonds are up 5%.

• We moved a little more than 8% of the portfolio from bonds to stocks.

• Since that date, that stock allocation would have added about 5% to returns. That’s value add that doesn’t require forecasting the pandemic or picking the right stock. It’s a increase to returns strictly due to rules-based portfolio management.

·         Around St. Patrick’s Day last year, more or less across our client base, this is what we did.  

·         I suppose there’s a reason Bob Enright checks that we wear green on St. Patrick’s Day. Our timing could hardly have been better.

·         That’s not to say that rebalancing has anything to do with trying to “time the market”. These trades did not reflect a call that the market was cheap or a belief that the market was poised to rebound.

·         Rather, it was the execution of a system we had premeditated and implemented for the rare but inevitable periods where the market hits us with extreme volatility.

BEHAVIORAL MANAGEMENT

·         Lastly, I’ll speak to why it’s necessary to have a system.

·         401(k)s are again a good analogy. A 401(k)’s beauty is automated investing – no action required. If every two weeks you had to log in and elect to invest, that would bring all sorts of biases to the table – “an unexpected bill came up … I’ll pass this time”. Or, “gosh the world is falling apart, it doesn’t seem like a good time to invest.”

·         We - like everyone - are susceptible to the same biases. I’ll speak for myself, if you had asked me last year whether it was a good time to invest, I probably would have hemmed and hawed and maybe mustered lukewarm enthusiasm. The world and future had never seemed bleaker or more uncertain.

·         Yet, as we’ve seen over the last year, bear markets often produce the best investment opportunities. Rebalancing systems are a necessary way to systematize investing and enforce the discipline to act in the face of counter-productive human instincts.

·         We often get the question - what happens if the market tanks again? And as unsatisfying as it may be, this story is our answer. We likely won’t be as fortunate with timing again. Nonetheless, last year’s experience validates the necessity of having a plan - to ensure decision-making is anchored to time-tested principles.

·         Hope this was a helpful look at what was a giant difference making to our portfolios over the last year. March seems like a different world but the intensity of the experience, particularly when it comes to rebalancing, will stay with us for a long time. Thanks for watching.

Burton Enright Welch is an independent, fee-only financial planning and investment management firm based out of Walnut Creek, California