It’s been hammered into most of us average folks to follow some basic tenets of investing: Buy low, sell high. Hold for the long term. Dollar cost average. Keep fees and expenses low. Invest in index funds.
Last week one of those widely held principles was called into question, with experts cited in the Wall Street Journal doubting whether it’s really worth it for investors to rebalance their portfolios of stocks and bonds. This strategy is thought to reduce risk, thus helping folks to sleep more soundly.
Stocks and bonds tend to move in different directions. If your 50-50 portfolio spins out to 70-30 because your stocks shoot up, most financial managers will advise you take some winnings off the table by selling the more successful stocks and buying cheaper ones or diversifying into bonds or cash.
That’s most financial advisers. Not all.
“I’m not anti-rebalancing. I’m skeptical,” Michael Falk, a chartered financial analyst and partner at Focus Consulting, said in an interview.
Falk said the idea behind rebalancing, like most logical investing, is simple. But so are other parts of investing doctrine: “buy low, sell high” and “buy and hold.”
“Simple is not easy,” he said. “You have to know when you can take advantage of simple math.”
The Journal cites a recent report by Michael Edesess, a mathematician and chief investment strategist at Compendium Finance, which argues rebalancing is not necessarily more productive than sitting on your gains for the long haul.
“Contrary to common belief and to the misguided conclusions of most of the articles in academic finance journals, rebalancing offers no ‘free lunch,’ either in terms of enhanced return or reduced risk,” Edesess wrote in his report. “The choice of rebalancing as an investment discipline as compared with an alternative such as buy-and-hold is simply a risk-return trade-off — though one that is a little more subtle than most.
“The benefits of rebalancing are far smaller than what advisers have come to believe,” he wrote.
Falk said the premise is based on selling the winners and allowing the losers to regress to the mean. But, he adds, “not everything regresses to the mean.”
He also notes that not everything regresses at the same time. Some stocks die, some simply lag, and some investments may take decades to reach their “promised land.”
“If you had a 50-50 stock-bond allocation goal, then the last five years could have seen your allocation change closer to 70-30 now,” Falk said. “You may be taking more risk. However, the question is if you sell stocks and buy bonds, do you really want to buy bonds right now, with what’s going on with the interest rate cycle?”
Falk went on: “Now is a good time and perfect example why to question whether you want to use this alleged best practice.”
Falk sees two things happening if you don’t rebalance. First, the markets may do it for you — which could hurt.
Or “over time, your winners will begin to be a bigger and bigger allocation in your portfolio, and your losers would shrink and become less important over time,” he said. “This has been shown to ‘win’ if you have decades, but who has that amount of time?”
The more you play around with your money, the more likely you are to incur some sort of fee.
“Rebalancing is active-management,” Falk said, “and as we have learned active-management has costs (think rebalancing in taxable accounts) and doesn’t always win.”
David Kass, a professor of finance at the University of Maryland, said most professional investors like Warren Buffett do not rebalance, but it makes sense for the rest of us. Kass even recommends rebalancing for a local nonprofit, where he sits on the investment committee.
“For most people and nonprofit institutions, rebalancing makes sense as a control for risk,” Kass said, pointing out that the Dow Jones industrial average declined 55 percent between October 2007 and March 2009. Average investors may not have the stomach for that kind of drop, particularly those closing in on retirement.
“Each investor or institution has his or its degree of risk tolerance or risk aversion,” Kass said. “Even though a buy-and-hold strategy of investing in equities is likely to outperform a rebalancing strategy between stocks and bonds in the long run, risk is better controlled in the short run.”
“I personally do not rebalance,” he said. “Certainly, Warren Buffett does not. For most individuals and institutions, it’s a wise idea to basically control the amount of risk in the overall portfolio by setting targets for the percentage of your portfolio that you would want in equities, in debt securities or bonds, and in cash, certificates of deposit, Treasury notes and Treasury bills.”
Stephen Horan, managing director of credentialing at the CFA Institute, is a fan of periodic rebalancing, calling it a “great discipline,” even if it means more trading.
“Studies show that the more that individual investors trade, the worse their outcomes,” Horan said in an email. “Portfolio rebalancing, however, is good corporate hygiene which actually counters some of the influences that lead to the trading performance drag.”