You may have heard of a highly promoted investment strategy known as rebalancing. While rebalancing investment services provide potential benefits, are they worth the costs? In this post, we will delve into what portfolio rebalancing entails and explore some advantages and potential drawbacks to this investment approach.
Portfolio rebalancing seeks to manage the risk of loss by adhering to a specific mix of investments (e.g., 70% equities and 30% fixed-income investments). The rebalancing approach depends on setting predefined targets, such as how much to allocate to stocks, bonds, and real estate. The purpose of these targets is to reduce risk by seeking to maintain a level of exposure to different asset classes consistent with one’s spending needs and risk tolerance. In the case of stocks, stock market exposure an investment portfolio has, the more volatility the investor should expect. Higher levels of volatility can be problematic if the stock market declines and stocks are needed to meet short-term spending needs. In this scenario, the risk is that stocks may need to be sold at depressed prices to meet short-term spending needs. A rebalancing approach seeks to avoid this scenario by limiting a portfolio’s exposure to equities relative to the investor’s spending needs.
Potential Drawbacks to Portfolio Rebalancing
While rebalancing sounds beneficial in theory, this strategy can have significant flaws in practice. Suppose the primary driver of the rebalancing decision is to adhere to an asset allocation target (i.e., increase the portfolio’s stock allocation to 70%). Without ample consideration of valuations, the investor may be grossly overpaying for investments to achieve an asset allocation target.
In the previous example, the asset allocation target drives the investment decision rather than seeking an answer to this common-sense question: “Are these investments a good value for my money?” When valuations are ignored with rebalancing, which is not uncommon, the risk of loss can increase if overvalued investments are purchased to achieve target allocations. Conversely, potential returns can be reduced when undervalued investments with positive long-term growth prospects are sold to meet target allocations.
When seeking to maintain target allocations with rebalancing, the net result can be higher taxes through frequent trading in non-qualified accounts (i.e., joint brokerage accounts, trust accounts, etc.). Also, the potential benefits of rebalancing in tax-deferred retirement accounts are questionable for long-term investors. Assuming positive market returns over time and no short-term spending needs from a diversified retirement account for many years, seeking to reduce short-term volatility through rebalancing could be of little consequence. To quote the famed investor Jack Bogle regarding his views on rebalancing, “I don’t think you need it…it’s overmanaging.” 1
Our Views on Rebalancing
If an investment approach such as rebalancing results in a higher risk of loss and lower potential returns through additional taxes and fees, the net result can be reduced financial security over time. Such an outcome can translate into reduced income during retirement and a higher probability of outliving your assets.
We believe that arbitrarily rebalancing, such as on a monthly or quarterly basis based on asset allocation targets without ample consideration of valuations, is not a wise approach. From our perspective, rebalancing is a suggestion on how a portfolio should be allocated rather than a hard and fast rule. There are occasions where rebalancing makes sense, but there are also scenarios in which a rebalancing approach can prove costly. There are also no guarantees of success with any investment approach with a risk of loss, including rebalancing.
To reduce or eliminate rebalancing fees, we recommend maintaining a “rainy day fund” for emergencies (e.g., unexpected expenses, loss of employment, etc.) At a minimum, this account should meet your spending needs for at least six months to a year and have little or no risk of loss (e.g., FDIC-insured CDs, T-Bills). This account should not be subject to rebalancing costs or other advisory fees.
If you have any questions regarding portfolio rebalancing or other investment approaches, call us at (713) 850-8900. We would be happy to address your questions
Citation(s):
1 Morningstar Interview: Bogle: Be Sensible About Rebalancing | Morningstar
https://www.morningstar.com/articles/615379/bogle-be-sensible-about-rebalancing
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About The Goff Financial Group: As a fully independent Registered Investment Advisor, the Goff Financial Group is not owned or controlled by any bank, brokerage firm, mutual fund company or any other company. The company does not receive any fees or commissions from any financial products and works solely for its clients on a fee-only basis. Disclaimer: This material was prepared using third party resources, and does not necessarily represent the current views of The Goff Financial Group which are subject to change without notice. This information has been derived from sources believed to be accurate. Please note – investing involves risk, and past performance is no guarantee of future results. The publisher is not engaged in rendering tax or legal advice. If assistance is needed, the reader is advised to engage the services of a competent professional. This information should not be construed as financial, investment, tax or legal advice and may not be relied on for the purpose of avoiding any Federal tax penalty. This document is neither a solicitation nor recommendation to purchase or sell any investment or insurance product or service, and should not be relied upon as such. All indices are unmanaged and are not illustrative of any particular investment.
