Practicing regular, systematic portfolio rebalancing can seem contrarian to many investors, says Elizabeth Harding, an investment adviser with Richardson GMP in Burlington.Glen Lowson/The Globe and Mail
As markets teeter back and forth amid unprecedented volatility, investors who fear suffering losses might be tempted to rebalance their portfolios.
Tinkering with your investments in the midst of market upheaval driven by fear, greed, low interest rates and geopolitical unrest – just to name a few – is generally not an effective way to rebalance, experts say.
"It's important not to let emotions drive your investment decisions, because you don't want to be rebalancing for the wrong reasons," says Bob Stammers, director of investor education at the CFA (Chartered Financial Analyst) Institute in New York.
And rebalancing out of the fear of substantial losses is a "wrong reason," he adds.
Instead, rebalancing should be part of an overarching strategy that is not driven by market losses, Mr Stammers adds. The decision to rebalance should be made according to your portfolio's asset allocation requirements, ensuring the mix of bonds, stocks and cash reflects long-term goals.
To that end, investors generally need to assess their portfolio regularly, maybe once or twice a year, to ensure its asset allocation still aligns with their long-term needs.
For example, say you plan to retire in 10 years, and you have determined that a portfolio of 50 per cent stock, 40 per cent bonds and 10 per cent cash will best achieve that goal. During the course of markets hitting record highs, the equity component increases to 70 per cent of the portfolio. So you sell some stock and buy some bonds, and increase cash to rebalance the portfolio's asset allocation.
This strategy has proven effective in growing and preserving wealth over the long term, studies say. One oft-referred-to paper from the 1980s by Gary P. Brinson, L. Randolph Hood and Gilbert L. Beebower found that 94 per cent of the variation in a portfolio's return can be attributed to asset class selection, with stock picking and market timing playing a much smaller role in generating returns.
Yet systematic asset class selection and rebalancing is difficult for many investors to put into practice because it generally involves a contrarian mindset, says Elizabeth Harding, an investment adviser with Richardson GMP in Burlington.
"It's often uncomfortable because you're selling something that is doing well and buying into something that isn't doing well," she says.
Investors need to be disciplined, and having a plan that regularly evaluates a portfolio's asset allocation, and rebalancing when necessary, helps investors sell high and buy low.
Too often, however, investors consider rebalancing only in the midst of turmoil, which often has the opposite effect: buying high and selling low, Ms. Harding adds.
Some investors may be concerned about the negative impact of taking profits from their equity holdings to increase the fixed income component of their portfolio during this time of low interest rates, when even corporate bonds are paying historically low yields.
Adding to this concern, fixed income has experienced a 30-plus-year bull market as interest rates have fallen and bond values have risen. With rates hovering at all-time lows, however, central bankers are now more likely to hike rates than lower them. This will negatively affect the bond portion of your portfolio.
"No one should be buying fixed income thinking they're going to be getting a capital gain now, because interest rates are probably going to rise somewhat in the next few years," says Ben Kelly, an associate portfolio manager with BCV Asset Management in Winnipeg.
Still, most investors generally need fixed-income assets in their portfolios to provide steady, albeit low returns.
Some experts recommend short-duration bonds maturing in less than five years, so when interest rates rise, your bond holdings will not be as adversely affected. Yet no one can predict when rates will rise, so it's better to avoid making a prediction on duration, Mr. Kelly says.
"That's why we try to diversify around durations," he says. "We'll buy corporate bonds that go out three years all the way out to about eight years."
More than anything, fixed income assets are a "shock absorber" for your portfolio because they tend to increase or at least hold their value when stock markets fall, he says.
Yet the decision to own more bonds and less stock, or vice versa, must be driven by a long-term strategy that is periodically revisited, refined and rebalanced – only not too much, Mr. Stammers says.
"You've got to really set out in your plan why you're going to rebalance because it can involve significant costs and tax consequences," he says.
This is why many investors choose to let allocations fluctuate within an acceptable range without rebalancing. For example, a portfolio could hold between 50 and 60 per cent equities and 40 and 50 per cent bonds without the need to rebalance.
Regardless of how it's done, regular rebalancing can help keep your investment strategy on track. It's a good way to guard against deep market losses than trying to time the market, which, while not impossible, is unlikely.
"You're never going to catch a top or a bottom on any market," Ms. Harding says. "They're always going to go higher than you think and they're always going to go lower than you think."