By the very nature of being a seasoned investor, you’re already familiar with the fickle waves of the financial market. However, when the waves grow tumultuous, questions arise. A curious investor recently posed a question that resonates with many: “Does rebalancing essentially lock in losses? And when do I stop buying the stock market on sale?”
To answer this, let's first lay a foundation of understanding. Diversification, asset allocation, and rebalancing – these three pillars uphold the sanctum of portfolio management. Diversification spreads your bets, asset allocation gives those bets a structure, and rebalancing is the steadfast gatekeeper ensuring the structure remains intact. They are not isolated, but rather, a triad working in harmony.
Imagine a symphony – a magnificent piece where every instrument holds its significance. The orchestra's conductor, akin to the rebalancing process, ensures every note is played to perfection. If an instrument is out of tune or overpowers the others, the entire symphony is affected.
This brings us to a fundamental truth of investing: there's an inherent counter-cyclicality to rebalancing. By trimming winners to purchase losers, you’re essentially ensuring that your portfolio does not become overly weighted in one direction.
Now, let’s venture into a historical prism for clearer insight. If we travel back in time and explore the annual returns of stocks (S&P 500) and bonds (US 10-year treasuries) from 1928 to 2022, we find the following figures:
S&P 500: +9.6% p.a. 10-year treasuries: +4.6% p.a. Taking a simple average of a 60/40 stock-bond proxy would give a return of 7.6%. However, with annual rebalancing, this jumps to 8.2%. The magic 0.6% is not mere luck; it's the “rebalancing bonus”. It’s that little extra you gain by ensuring that your portfolio, while taking advantage of market swings, doesn’t get too carried away by them.
However, there's a caveat. There is too much of a good thing. A daily rebalancing act, can quickly become excessive. Vanguard, in its comprehensive study, revealed that rebalancing too often might end up eroding the benefits. Their suggestion? An annual rebalance. This not only streamlines the portfolio but also provides enough room for assets to grow. The below chart highlights this rebalancing bonus;
Of course, there's no one-size-fits-all in the intricate realm of investment. Some might prefer threshold-based rebalancing, acting only when allocations drift too far from the target. Others might combine periodic and threshold-based rebalancing. Whatever your preference, the golden rule remains: maintain a clear strategy, adhere to it, and, if possible, automate the process. Automation, in many ways, is like setting the cruise control on a car — it ensures consistent speed despite the undulating roads of the market.
I also wanted to address the notion of “buying the stock market on sale”. When does one stop? For individual stocks, some might never recover; they are, unfortunately, financial Icaruses that fly too close to the sun. But if we’re discussing broader indices, history has shown that declines, more often than not, are transient phases. They offer ripe opportunities for those with the patience and the courage to invest during downturns.
If you’re in the fortunate position of making regular contributions, market downturns should be seen not with trepidation but with eagerness. Acquiring assets at reduced prices means you're laying a foundation for potential future gains. As the old adage goes, "Buy low, sell high". It's in these downturns that the "buy low" opportunities present themselves most clearly.
In conclusion, rebalancing doesn’t 'lock in' losses. Instead, it’s a protective measure to ensure your financial symphony continues playing harmoniously. If done prudently, with a good understanding of the underlying principles of diversification and asset allocation, rebalancing can not only safeguard but also enhance your portfolio's performance.
As you navigate the vast seas of investment, let diversification be your compass, asset allocation your map, and rebalancing your anchor. With these three at your side, the journey, though not always smooth, will likely be fruitful.
