Tending Your Financial Garden: Portfolio Rebalancing

22nd May / 2020
Tending Your Financial Garden: Portfolio Rebalancing

During the weeks of shelter-at-home, I’m sure we’ve all tried some new activities or things to pass the days in a safe, productive way. One of the things to which I’ve had my first exposure recently is gardening. My son’s elementary school has a wonderful garden whose benefits are more than just aesthetic: The Master Gardener who runs it builds curriculums for the K-6 teachers to use this unique environment in some of their lessons. For the past two school years, my wife has been the volunteer caretaker of the garden, spending 5-10 hours a week supporting the Master Gardener.

Over the past few weeks, my son and I have joined my wife on her Sunday trips to the garden to help with a variety of maintenance activities that a garden of this size requires: Watering, weeding, composting, fixing severed irrigation lines and an activity called “dead-heading”. When my wife first mentioned the term, I was confused as to how a psychedelic concert had received permission to go on in these days of social distancing, and why she wanted to go. She quickly enlightened me that she was not talking about the Grateful Dead, but about the activity of identifying and trimming the subset of flowers on a plant that are fading and dying. This process is not done to make the plant look pretty today, she said, it actually improves the long-term health and performance of the plant as afterward the plant now channels more energy into new blossoms, rather than those that have already served their purpose.

Portfolio rebalancing is the financial equivalent of dead-heading plants. The first important element in portfolio rebalancing is developing a target weighting for each asset class (U.S. stocks, international stocks, bonds, etc.) in your portfolio. The most important target is your split between more volatile assets with greater expected returns (stocks) and more conservative assets designed to provide stability and shorter-term liquidity (high quality bonds). Your target should be specific to you and should be based on two important variables:

1. The level of long-term returns that your financial plan assumes you need to achieve your definition of success, and

2. The level of short-term volatility and discomfort you are willing to tolerate in pursuit of those long-term returns.

As time passes, the differing performance of individual asset classes in your portfolio can pull it off target. The asset classes that perform relatively well will become a larger weight and those that lag will become a smaller weight. Rebalancing involves trimming small amounts from areas of your portfolio that have done relatively well recently and investing the process in the assets classes that have lagged recently to bring your portfolio back in line with its intended target.

As an example, if left untended, a simple two-asset portfolio that started on January 1, 2020 with 60% in global stocks (MSCI ACWI index) and 40% in bonds (5-year Treasury index) had seen market movements cause its allocation to stocks fall to less than 53% by March 31. Given that the investor’s long-term plan assumes their portfolio will capture the returns of a 60/40 allocation, they now have a risk of not achieving that expected long-term return because of their now-reduced allocation to stocks.

From an emotional perspective, portfolio rebalancing can be one of the most challenging actions for an investor to take because it always feels like one is going “against the trend”: It means potentially buying stocks during dramatic declines like the one we all experienced in March 2020 and selling stocks at other times after they have performed remarkably well. But those actions may materially improve the investor’s long-term wealth relative to a “do-nothing” approach.

The graphics below cover the past three major stock market declines, periods starting in March 1973, March 2000 and October 2007, respectively. Each graphic compares the long-term growth of two portfolios that each started with a 60/40 allocation to the stock and bond asset classes described above. One portfolio was rebalanced at each month-end when it had strayed more than 10% in either direction from its 60/40 target (when it reached 50/50 or 70/30) and the other portfolio was never traded, with only the eventual recovery of the stock market bringing it back to its target weights.

As you can see, the act of rebalancing in down markets resulted in incremental wealth to the hypothetical investor in these historical cases. Rebalancing is equally important in frothy markets when the stock market has performed well for a period of years, as letting a portfolio’s weighting to stocks grow materially in excess of its target will mean greater emotional and possibly financial challenges when a dramatic stock market decline eventually occurs.

Of course, it is always important to consider all the elements of one’s financial situation when thinking about portfolio decisions. Tax consequences, trading costs and future cash needs are just a few considerations that should be reviewed prior to any rebalancing activity.

A tangential benefit to portfolio rebalancing is an emotional one. As humans, we all feel better when we are trying to take action in times of stress and uncertainty. Unfortunately, many of the actions that investors consider during these times are the equivalent of digging up their entire garden, which often causes more problems than it solves. On the other hand, portfolio rebalancing, like dead-heading plants during COVID-19, is an action investors can take that we believe will benefit them in the future.

Important Disclosure:

Data Source: Dimensional Returns 3.0 Software.

Information provided is general in nature and is not intended to be construed as legal, tax advice, financial advice or a specific recommendation. TFO Phoenix, Inc. is not engaged in the practice of law. A professional adviser should be consulted before implementing any of the options presented. All expressions of opinion are subject to change and should not be construed as an offer to buy or sell, or a solicitation of any offer to buy or sell the securities mentioned.

Past performance may not be indicative of future results. Therefore, no current or prospective client should assume that the future performance of any specific investment or strategy will be profitable or equal to past performance levels. All investment strategies have the potential for profit or loss. Different types of investments involve varying degrees of risk, and there can be no assurance that any specific investment or strategy will be suitable or profitable for an investor’s portfolio. There are no assurances that an investor’s portfolio will match or outperform any particular benchmark. Asset allocation and diversification do not assure or guarantee better performance and cannot eliminate the risk of investment losses.

TFO Phoenix, Inc. is an SEC registered investment advisor and only transacts business in states where it is properly registered, or is excluded or exempted from registration requirements. SEC registration does not constitute an endorsement of the firm by the Commission nor does it indicate that the advisor has attained a particular level of skill or ability.