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Rebalancing: A simple, if unappreciated, way to enhance investing

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The bull market in stocks has been running for nearly eight and a half years — one of the longest upward stretches ever. Have you rebalanced your portfolio lately?

You might want to think about rebalancing to lower your risk and possibly improve performance. This buy-low, sell-high approach can help you stick to a plan and overcome harmful psychological tendencies.

Yes, psychological. Rebalancing can be an effective way to deal with greed, fear and indecision.

“Consistent rebalancing is a reliable, and often underappreciated, source of higher risk-adjusted performance for the patient investor,” wrote Brent Leadbetter and two colleagues at investment firm Research Affiliates in a recent report.

It can help investors overcome the natural tendency to wait and see before tweaking their investment mix.

How rebalancing works

It’s a fairly simple concept: With rebalancing, you occasionally want to cash in some profits on high-flying stocks or other assets, then reinvest the proceeds in laggards. The idea is to bring your overall portfolio back in line with a suitable long-term mix that’s suitable for you. Rebalancing assumes you have a target mix of stocks, bonds, cash and other investments and want to stick with it.

Suppose you earlier decided that a split of 60 percent stocks/stock funds and 40 percent bonds/bond funds is a good mix. If you’re currently sitting at 65 percent/35 percent, for example, you might want to pull assets equal to five percentage points from stocks and reinvest them in bonds, to get back to that 60/40 position.

Stock prices have tripled since the long bull market began in March 2009. Consequently, you might have a bit too much in stocks, especially as you’re older now and presumably want a less-volatile portfolio.

“The biggest advantage of rebalancing is that it helps you manage risk,” said David Fernandez, a certified financial planner at Wealth Engineering in Scottsdale. “The U.S. stock market has done so well lately that, if you’re not rebalancing, you’ll wind up with a portfolio that’s heavily concentrated in (large) U.S. stocks.”

Behavioral issues

A less-obvious aspect to rebalancing is that it can help investors overcome psychological tendencies that can prove harmful.

Greed is one. As explained by the Research Affiliates report, when investors are sitting on large paper profits in the stock market, they could become susceptible to the “house money” effect. This explains the tendency of casino gamblers on a winning streak to stay too long at the table. So too with many stock-market investors.

Fear of missing out is another. Many of us tend to remain heavily invested in stocks even when it becomes more risky to do so, out of fear that our friends will keep bragging about all the money they’re making if the market keeps rising.

People are “evolutionary wired to follow the herd,” said the Research Affiliates report. That is, nobody wants to feel stupid, or even ostracized, by missing out on big gains.

These behaviors are easier to overcome if we stick to a plan. Rebalancing provides a discipline for taking such actions even when they don’t feel right.

Conversely, rebalancing also provides the justification for keeping at least a toehold in the stock market at all times. It can help you view bear markets not as cycles to be feared but as buying opportunities.

Betting on long-term averages

Still, it can be difficult emotionally to take some chips off the table during a market environment like that of the past eight-plus years, when the gains have rolled in fairly steadily. There’s a natural tendency not to want to sell winners prematurely.

However, rebalancing isn’t the same as market timing, which involves making big shifts into or out of the stock market, usually based on recent trading patterns, valuations or other news or developments. With rebalancing, the changes are more subtle, and they’re focused on getting back to a predetermined allocation or mix.

Rebalancing also involves moving among different investment subcategories. Foreign markets haven’t fared nearly as well as U.S. stocks in recent years and thus could be a good place to move some money, Fernandez noted.

Rebalancing rests on another assumption — that investment returns will tend to fluctuate more or less in line with their long-term averages. This is the concept of “reverting to the mean.” While individual stock prices can fluctuate wildly, the market as a whole has returned about 11 percent annually over time. After a big rally, stocks tend to cool off for a while. After a slump, they tend to recover. 

“A disciplined rebalancing approach continually positions our portfolios to reduce risk,” said Research Affiliates.

In fact, investors who rebalance don’t necessarily give up all that much in gains, even when the market is advancing. For example, the all-stock Standard & Poor’s 500 index generated an average gain of 7.2 percent annually over the 20 years through 2017, noted JPMorgan Asset Management. A 60 percent/40 percent stock-bond split didn’t do all that much worse, returning 6.4 percent a year, but with less risk.

Tips for success

Rebalancing is a simple concept, but there are ways to make it more effective. Here are some tips on that:

  • Rebalancing works best inside Individual Retirement Accounts, 401(k) plans and other accounts where buy/sell decisions don’t trigger taxable gains or losses. If rebalancing would exert a tax impact or result in big trading costs, you might want to rebalance less frequently.
  • You don’t need to rebalance all that often. Many advisers suggest doing so about once a year or after your portfolio has drifted out of whack by maybe five percentage points.
  • Rather than selling assets to rebalance, an alternative would be to earmark new investment dollars or reinvested dividends into stocks or bonds that have lagged.
  • Rebalancing doesn’t work as well with individual stocks or bonds, which conceivably could lose all their value. You want to use broadly diversified funds.

As noted, the flip side to rebalancing is that it can slow your gains during periods of sustained rising prices. But after more than eight years of a mostly upward trend, the odds are increasing for a major, downward shift in direction.

Reach the reporter at russ.wiles@arizonarepublic.com or 602-444-8616.

READ MORE:

  • Don’t know what to do with your 401(k) plan? Consider moving it to an IRA
  • Here’s what economic growth means for your investments
  • Keys to better investing may be hiding in your tax return

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