Image Credit: Christophe Vorlet
By Jason Zweig | Nov. 9, 2012 5:39 p.m. ET
Perhaps you can beat the market after all — by trying not to.
In typical markets and a basic portfolio, rebalancing — or trimming your winners and adding to your losers — can add 0.25 to 0.5 percentage points to your annual return, estimates William Bernstein, an investment manager at Efficient Frontier Advisors in Eastford, Conn.
That might not sound like much, but with stock and bond markets looking as if they will deliver lackluster returns over the coming years, investors need to snatch every smidgen of extra return.
Are you what the great financial analyst Benjamin Graham called a “defensive investor” — someone who doesn’t want to work too hard at managing a portfolio? Rebalancing can get you a little more return and a little less risk with a minimum of effort.
To see how rebalancing works, contrast the Vanguard Balanced Index Fund with its underlying holdings. This fund keeps 60% of its assets in an index that captures the return of the broad U.S. stock market and 40% in a version of the Barclays Aggregate Bond index.
If, 10 years ago, you had invested in the two underlying indexes in the same 60/40 proportion and simply held on, you would have earned an annual average of 6.82% annually.
Over the same period, the fund returned an average of 7.04% a year — an extra 0.26 percentage point more than the average of its components.
How can the whole be greater than the sum of its parts?
Unlike its static underlying components, the Vanguard fund rebalances, buying the asset that has fallen below its target and (when necessary) selling the one that has risen above its set level. That keeps its mix of assets hewing tightly to its target 60/40 ratio of stocks to bonds.
In 2008 and early 2009, the fund bought stocks “as they got cheaper and cheaper all the way down to the bottom, the point of maximum pain,” says Daniel Newhall, a portfolio analyst at Vanguard Group.
As a result, when the stock market roared back, doubling over the ensuing two years, you participated less in that comeback. But because the fund kept 60% in stocks all along, it got a bigger benefit from the rebound.
It is important to note that rebalancing is likely, but not certain, to work. If one asset does far better than all the others in your portfolio, then any money you move to the other investments will lower your returns.
Furthermore, there’s no guarantee that what goes down will go back up; a Japanese investor rebalancing into stocks has thrown good money after bad for decades.
“I don’t think there have been enough major cycles to say definitively that [rebalancing] will be a good thing in the future,” says William Sharpe, a retired finance professor at Stanford University who shared the Nobel Prize in economics in 1990.
Above all, rebalancing is psychologically painful. Investors want to bask in the pride of picking winners and to avoid the pain of recognizing losers. Rebalancing forces you to sell pleasure and buy pain — a bad emotional trade.
Rebalancing makes even the biggest investors suffer. In 2010, the Nacubo-Commonfund Study of Endowments, a survey of investment staff at 850 colleges and universities with a total of $346 billion in assets, found that 18% of the institutions didn’t rebalance in that fiscal year. Some were “waiting for the market to settle down.” One institution said its investment committee was too “paralyzed with indecision” to rebalance.
A few rules can help.
First, remember that the rebalancing bonus is small. If you incur any commissions or other trading costs, or have to pay capital-gains tax, you can negate all of your likely gains. So focus your rebalancing efforts inside a retirement account, where taxes won’t be an issue and you shouldn’t have to pay brokerage fees.
Trimming back your winning assets does enable you to lock in a gain and pat yourself on the back, so it hurts a bit less than buying more of what is performing badly.
Taking care not to incur taxable gains, rebalance first by selling whatever exceeds your preset limits. If this week’s selloff in stocks continues, many investors who aim to hold, say, 40% in fixed-income assets might soon need to trim their bonds to get back into balance.
Don’t fuss over frequency. Mr. Bernstein says there is no reason to believe that rebalancing monthly or on another frequent schedule is much better than doing it annually.
Even once every two or three years would be fine, he says — except that the hardest part of rebalancing is remembering to do it and following through on that intention. Wait too long and you might forget about it. There is no better time than the turn of the year to make a rebalancing resolution you can keep.
Source: The Wall Street Journal, https://www.wsj.com/articles/SB10001424127887324073504578108963196064662
For further reading:
Definitions of FINANCIAL ADVISOR, INDIVIDUAL INVESTOR, INSTITUTIONAL INVESTOR, REBALANCE, RETAIL INVESTOR, SMART MONEY, SOPHISTICATED INVESTOR, and VOLATILITY in The Devil’s Financial Dictionary
Chapter Eight, “The Investor and Market Fluctuations,” in The Intelligent Investor
Chapter Nine, “Regret,” in Your Money and Your Brain
William J. Bernstein, EfficientFrontier.com, “The Rebalancing Bonus: Theory and Practice”