Portfolio Rebalancing: The Top 4 Benefits for Retirement Investors
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Welcome to the Stay Wealthy Podcast. I'm your host, Taylor Schulte, and today we're talking about portfolio rebalancing, what it is, and the top four benefits to retirement savers. And this is part one of a two-part mini-series. Next week on the show, I'm going to wrap this all up by sharing all the big mistakes and pitfalls to look out for when rebalancing your portfolio.

For all the links and resources mentioned for today's episode, head over to youstaywealthy.com forward slash 96. And we're going to get right into it so I can make best use of your time today. So what is portfolio rebalancing?

Let's just start with making the assumption that for everybody listening, you have a documented asset allocation for your investments. For example, you might have 60% in stocks and 40% in bonds. Now, in reality, your asset allocation might look more like 20% US stocks, 20% international, 10% emerging market stocks, and so on. But for now, out of the gates, let's just keep it simple and focus on a simple asset allocation of stocks versus bonds.

As I've discussed at length on this podcast, it's important to have this allocation written down and formalized on what we call an investment policy statement, or also known as an IPS. And the IPS, in addition to noting and documenting your target asset allocation, it will also, or it should also, outline the parameters under which your portfolio will be rebalanced.

For example, your IPS might say something like a rebalance will occur if one or more of the underlying asset classes within the portfolio varies plus or minus 5% from its target allocation. In other words, if you're targeting an allocation of, let's say 60% stocks and 40% bonds, you're

and the stock market goes on a tear, your allocation might turn into 65% stocks and 35% bonds in which you would be alerted to process a rebalance that the target allocation of 60, 40 varied by 5% per your investment policy statement. And that's your signal to rebalance.

Now, back to our initial question of what is rebalancing? Rebalancing is simply your portfolio, the process of bringing it and its asset allocation back to the target percentages that you or your financial advisor have established.

The need to rebalance arises from this uneven performance of different types of investments under various market and economic conditions. If all of your investments are moving in the same direction during every single economic cycle, you would not be diversified and that would be an entirely different problem for us to talk about and address.

But for properly constructed portfolios, it's very common for some of the investments in the portfolio to zig when others zag. And this requires the puzzle pieces to be put back together periodically to avoid ending up with an asset allocation that doesn't match up with your financial plan and your goals.

And remember that this works both ways when analyzing the risk of your portfolio. In my previous example, I shared that the stock market skyrocketing could lead your portfolio to be in a more risky position than you had intended. But the stock market tanking can do the opposite in that you can end up with a much more conservative portfolio than you had been targeting.

that 60% stock, 40% bond portfolio could easily turn into 45% stocks and 55% bonds if it's left untouched during a prolonged bear market. When I talk about things in your financial life, in our financial life that you can control, rebalancing is one of them. You can take control of the amount of risk that you're taking with your investments and potentially your return, which we'll talk about here in a minute.

But that doesn't mean that you can just neglect your portfolio and just buy and hold and never look at it again. Without ongoing attention and care, you can easily lose control and you could find yourself in a situation that's not easy to recover from.

One of the most common questions I hear from investors is with regards to portfolio rebalancing is, well, when should I rebalance my portfolio? I understand what it is and why it's important, but when should I rebalance my portfolio? And here's the thing, which I'll elaborate on when we get to the pitfalls to watch out for.

But rebalancing your portfolio too frequently can actually be harmful. We want to consider rebalances at reasonable intervals, which for many investors and professionals is annually, semi-annually or quarterly. And there's a lot of things that that depend there.

Two common exceptions to this frequency of annual, semi-annual, or quarterly, two common exceptions would be a major market move in either direction, either up or down, or a large deposit or withdrawal. So one of those two or three events there might trigger a rebalance outside of that normal frequency or schedule.

Remember that you need to take your entire global portfolio into consideration when processing rebalances. And what I mean by that is that you might not rebalance every account you have in isolation, especially if there are tax consequences that you're navigating around.

More common is following what we call an asset location strategy, not allocation, but location where each account of yours only holds investments that are prudent and fitting for the tax treatment of that account.

A common asset location strategy, which I've discussed before, is to hold all of your bonds in your retirement accounts, like your 401ks and traditional IRAs, and all of your stocks in a taxable brokerage account. If you have multiple retirement accounts between two different spouses, rebalancing all of these accounts and taking asset location into consideration, it, as you can imagine, can become quite the math problem to solve for.

But even if you don't pursue an asset location strategy, be sure that you're looking at all of your investment accounts and taking them all into consideration when creating a systematic portfolio rebalancing plan. It's not going to do you any good if one of your investment accounts has a good rebalancing system and has a documented investment policy statement, and then all the others are neglected and are on a totally different path.

So now that we kind of got all the basics out of the way, let's talk about the benefits of portfolio rebalancing. And there are four key benefits that I want to highlight today. The first benefit is this benefit of buying low and selling high. And yes, rebalancing actually allows you to follow this old adage pretty well, and you don't even need to be a market timer to do it. Let me explain.

The process of rebalancing inherently directs investors to sell the things in their portfolio that have done really well and buy the things that haven't done very well. So if we go back to my initial example at the top of the show, if our target portfolio is 60% in stocks and 40% in bonds and the stock market's been skyrocketing and we look at it and now it's 65% in stocks and 35% in bonds, then

This act of rebalancing this portfolio is essentially going to cause me to sell my winners, i.e. stocks, and buy my losers, i.e. bonds. I'm buying low, right? I'm buying bonds low and I'm selling my stocks high. However, and this is a big however,

It's important to note here in this example that we're selling investments with higher expected future returns. Those would be stocks. And we're buying investments with lower expected future returns, which would be our bonds.

So when you rebalance between high return asset classes and low return asset classes like stocks and bonds, you're actually going to be reducing your long term returns. It's going to help you lower your risk and manage your risk, but it's also going to lower your expected future returns. And that's because the stock market, as we all know, carries more risk and has higher expected returns than the bond market.

The stock market also historically has ended the year in positive territory 75% of the time. So it goes up more often than it goes down. And it also has a higher rate of return than the bond market. So if I never touch my portfolio and I let my 60% stock, 40% bond portfolio drift into a 70-30 and then further into an 80-20 and I

never rebalanced it, well, I should expect higher rates of return because I'm now taking more and more risk as the years go on. If I rebalance it continually back to a 60-40, well, I'm taking risk off the table. I'm reducing my risk, which again, inherently is going to reduce my returns.

Now, with that being said, it is possible to enhance your long-term returns by rebalancing amongst your stocks or other high-risk, high-return asset classes.

For example, inside of your US stock allocation, you might have an allocation to large cap stocks and small cap stocks. And like we've seen in recent years, these two volatile asset classes often move in different directions and rebalancing between these two asset classes versus just buying and holding them has shown to actually boost long-term returns, according to a research paper by William Bernstein, which I'll be sure to link to in the show notes.

In summary here, Bernstein found that for similar returning asset classes, so similar to returning, that would be large cap stocks and small caps, not identical returns, but similar returning asset classes, the higher the volatility of those assets and the lower their correlations are to each other, the more rebalancing opportunities you have available and the greater potential that rebalancing bonus, as he calls it, will be.

This all leads to benefit number two, which kind of summarizes benefit number one. And that is rebalancing allows you to maintain your risk and your desired asset allocation. If you do it correctly, if you process your rebalancing correctly, at the end of the day, systematic portfolio rebalancing produces a benefit to the investor, either in the form of higher long-term returns, which we just talked about, or the management of risk.

The goal for many investors, which is especially true for the clients that we work with at my firm, isn't necessarily to boost returns and try to beat the market, but it's to manage risk. I've said it tons of times before here, those three to five years prior to retirement and those first three to five years in retirement, those are arguably the most vulnerable years of your investments and your financial plan and managing risk

and avoiding those large drawdowns during those time periods is absolutely critical. The good thing is, is that systematic rebalancing is a huge help to managing risk during that time period. Speaking of systematic, which you've heard me say a few times now, the third benefit to rebalancing is sticking to a rules-based, i.e. systematic approach with your investments to help you avoid costly mistakes.

So let me explain. Money is inherently an emotional topic and these emotions can be further exacerbated by the fact that it's impossible to consistently time the ups and downs of the market.

Which is why it's critical to document your target asset allocation. I don't care if it's on a napkin, on one piece of paper, but documenting your target asset allocation, bringing it to life, and then developing a rules-based system for keeping your investments on track.

a rules-based approach is going to help protect you from you. It's easy to get excited by a thriving stock market and get greedy and neglect to process that rebalance because you just think that the stock market is going to keep going up and up and up. And then like we saw last March, something catches everyone off guard, like a global pandemic that nobody saw coming and the market drops 30% right before your eyes. So by having a system in place,

or hiring a financial advisor to create and manage that system for you, it takes the emotion out of play and it ensures that your investments remain in line with your investment policy statement and your investment policy statement remains in line with your retirement plan. Like I've said, your retirement plan, or I should say,

Your investments shouldn't change unless your investment policy statement changes and your investment policy statement shouldn't change unless your retirement plan changes. So by having this system in place, it again protects you from you and ensures that everything remains in line working together towards your goals.

Number four, speaking of hiring a financial advisor, that is the fourth benefit of rebalancing, which is that it holds your financial advisor accountable. Retirement savers place a lot of trust in their financial advisor. Many of those people, those retirement savers, they want to know that one, their financial advisor has a documented investment plan in place and a system for managing the investments prudently.

And two, they want to know that there are guardrails in place to prevent their financial advisor from going rogue with their money and making a rash decision to say, you know, buy Bitcoin or buy GameStop stock or even just simply try to time the market by jumping in and out whenever they feel like it.

By having that investment policy statement in place with your financial advisor and a documented rebalancing plan, you can in turn feel more confident turning over the keys to a professional, knowing that there are ways to track their work and hold them accountable.

So to recap, the four benefits to portfolio rebalancing are one, buying low and selling high. Number two, managing risk and maintaining your target allocation. Number three, creating a rules-based approach to avoid costly mistakes. And number four, a method for holding your financial advisor accountable.

As mentioned at the top of the show, there are also a number of drawbacks and mistakes and pitfalls to watch out for when it comes to rebalancing, which I'll be sharing with you next week on the podcast in part two of this mini-series.

For the links and resources mentioned today, head over to youstaywealthy.com forward slash 96. Thank you as always for listening and I will see you back here next week. This podcast is for informational and entertainment purposes only and should not be relied upon as a basis for investment decisions. This podcast is not engaged in rendering legal, financial or other professional services.