Is It Time to Rebalance?

Editor's note: Read the latest on how the coronavirus is rattling the markets and what investors can do to navigate it.

Stocks have been on a wild ride so far in 2020. The S&P 500 started strong, lost 20% during the first quarter of 2020 (its worst showing since 2008), only to recoup most of those losses so far in the second quarter. More recently, stocks have slid again.

This fast-changing, uncertain backdrop has many investors scratching their heads. While they may have added to stocks during the March downdraft (or wish they had), stocks’ recent snapback has been so pronounced that they may be wondering whether it’s actually time to take risk off the table. And if it is, what’s the best way to do so?

Enter rebalancing, which is a disciplined way to make sure your portfolio’s risk level remains in check. In contrast with market-timing, which can involve dramatic, “you’re in or you’re out” shifts among asset classes, rebalancing means that you’re making changes only to bring its allocations back in line with your plan.

The Why and How of Rebalancing To be clear, data don't generally support that basic rebalancing--from stocks into bonds or vice versa, depending on which has performed best--improves a portfolio's return level. And there's no intuitive reason to assume that it would. After all, rebalancing entails trimming appreciated securities, so it stands to reason that periodically cutting appreciated stocks, which have historically outperformed other asset classes, would not be additive to returns.

Instead, the main virtue of rebalancing is in the realm of risk reduction. Several studies indicate that portfolios that are periodically rebalanced back to a target asset mix have lower risk levels than portfolios whose risk levels are never adjusted.

Yet even as rebalancing at the asset-class level will have the biggest impact on how your portfolio behaves, it's not the only way to rebalance. It's also possible to rebalance within asset classes. If growth stocks have outperformed dramatically (and they have), you'd peel back on them and add to value names. If U.S. stocks have outperformed foreign dramatically (and they have over the past decade), you'd cut back on them and add to non-U.S. names. Because a person who's rebalancing within the equity portion of her portfolio is periodically cutting exposure to a more expensive asset class in favor of a more favorably valued one, it stands to reason that this type of rebalancing has more potential to enhance returns than does rebalancing at the asset-class level.

Which type of rebalancing you pursue depends on your life stage. If you’re getting close to retirement, your ability to handle big swings in your equity portfolio is diminished. You may still have a high risk tolerance--the ability to mentally tolerate losses from a stock-heavy portfolio. But if you need to withdraw from your stocks when they’re down, that has real repercussions for the viability of your plan. Rebalancing at the asset-class level should be job number one.

On the other hand, if you’re in the accumulation phase and have many years until retirement, risk reduction probably isn’t your main priority: returns enhancement is. Thus, you could benefit more from intra-asset-class rebalancing, even as you maintain an equity-heavy portfolio mix.

It’s also worth noting that you can engage in both types of rebalancing at the same time. For example, if you’ve determined that you need to cut back stocks and you’d also like to restore your portfolio’s balance of growth and value exposure, you can adjust your asset allocation by selling growth stocks/funds and moving the money into bonds.

And as always, be sure to take taxes and transaction costs into account when rebalancing.

Is It Time? Of course, the question about whether and how to rebalance depends completely on your situation: your personal asset-allocation targets, what you're trying to achieve (risk reduction, return enhancement, or both), and what kinds of thresholds you've set for determining whether it's time rebalance.

Yet even as rebalancing is pretty individual-specific, here’s a look at where hands-off investors would be with respect to asset-class exposure, Morningstar Style Box exposure, and geographic exposure if they’d made no changes to their portfolios over various time horizons. For the sake of simplicity, I've assumed 50/50 allocations for all of these examples, but real-world investors' portfolios will obviously be different.

Stocks Versus Bonds

1-Year: 50% stock/50% bond portfolio in June 2019-today: 48% stocks/52% bonds 3-Year: 50% stock/50% bond portfolio in June 2017-today: 52% stocks/48% bonds 5-Year: 50% stock/50% bond portfolio in June 2015-today: 56% stocks/44% bonds 10-Year: 50% stock/50% bond portfolio in June 2010-today: 69% stocks/31% bonds

These data suggest that recent market action shouldn't drive a big rush to rebalance. Yet rebalancing may be in order for investors who have been taking a laissez-faire, hands-off approach for a good long while now. A 50% stock/50% bond portfolio five years ago would now be 56% stock, whereas that same hands-off portfolio would have grown to be 69% equity between 2010 and 2020. Meanwhile, the investor is presumably closer to needing his money. I assumed a total stock market/total bond market index portfolio for these calculations; different fund selections would obviously yield different results.

Value Versus Growth

1-Year: 50% growth stock/50% value stock portfolio in June 2019-today: 56% growth stock/44% value stock 3-Year: 50% growth stock/50% value stock portfolio in June 2017-today: 58% growth stock/42% value stock 5-Year: 50% growth stock/50% value stock portfolio in June 2015-today: 59% growth stock/41% value stock 10-Year: 50% growth stock/50% value stock portfolio in June 2010-today: 61% growth stock/39% value stock

Assuming an investor is aiming to maintain balanced exposure to value and growth stocks--a big if, given the current mania for value names--the data suggest that rebalancing thresholds would have been breached over every time period I examined. Of course, rebalancing into value from growth hasn’t paid off in recent years, but Alex Bryan, Morningstar’s director of passive strategies research in North America, quite reasonably points out that the valuation differential between value and growth names can’t continue to widen indefinitely. I used Vanguard Growth Index VIGAX and Vanguard Value Index VVIAX for these calculations; different fund selections would obviously yield different results. If the value component of the portfolio emphasized small- and mid-cap stocks, for example, the differential would have been even more pronounced.

U.S. Versus Non-U.S.

1-Year: 50% U.S. stock/50% non-U.S. stock portfolio in June 2019-today: 52% U.S. stock/48% non-U.S. stock 3-Year: 50% U.S. stock/50% non-U.S. stock portfolio in June 2017-today: 56% U.S. stock/44% non-U.S. stock 5-Year: 50% U.S. stock/50% non-U.S. stock portfolio in June 2015-today: 58% U.S. stock/42% non-U.S. stock 10-Year: 50% U.S. stock/50% non-U.S. stock portfolio in June 2010-today: 67% U.S. stock/33% non-U.S. stock

U.S. and non-U.S. stock performance have been running pretty evenly recently, but U.S. stocks have outperformed significantly for the three-, five-, and 10-year periods. As a result, a portfolio’s geographic split may be an area of interest for people who haven’t rebalanced for a while. Of course, most investors don’t have portfolios that are equally balanced between U.S. and non-U.S. names; most professionally managed target-date funds steer about 40% of their equity allocations to non-U.S. names. But the effect of U.S. stock outperformance is directionally the same: A portfolio that was 60% U.S./40% non-U.S. 10 years ago would be 75% U.S./25% non-U.S. today. In an effort to limit security selection “noise,” I used a total U.S. market index fund/total international index fund for these calculations, but different fund choices would obviously yield different investment results.