How to rebalance a portfolio without moving money into losing investments

Question

I've read a number of conflicting opinions on whether portfolio rebalancing is a good idea. The question of whether rebalancing is a good idea has been addressed in some questions here, too, such as this one. From the accepted answer to that question,

An asset allocation formula is useful because it provides a way to manage risk. Rebalancing preserves your asset allocation. The investment risk of a well-diversified portfolio (with a few ETFs or mutual funds in there to get a wide range of stocks, bonds, and international exposure) is mostly proportional to the asset class distribution. If you started out with half-stocks and half-bonds, and stocks surged 100% over the past few years while bonds have stayed flat, then you may be left with (say) 66% stocks and 33% bonds. Your portfolio is now more vulnerable to future stock market drops (the risk associated with stocks).

I understand and accept that by leaving your portfolio in this state would basically be "doubling down" on stocks continuing to perform well relative to bonds. However, if stocks surged 100% and bonds were flat, wouldn't rebalancing cause you to sell an asset that was performing well (stocks went up 100%) in order to buy an underperforming asset (bonds were flat)? Also, almost by definition rebalancing involves making more trades than you would have otherwise; wouldn't the additional trading fees you incurred in doing so reduce the benefits of this strategy?

This Forbes article argues that

Rebalancing... smooths out investment returns and forces you to “sell high” and “buy low.” When one piece of your portfolio goes up, you may be inclined to put more money in that area since it is clearly doing well. But for the health of your portfolio, you should fight that impulse. As the past 25-years indicate, the best thing you can do is take profits from your winners from time to time.

That article (contrary to some other articles I've seen) argues that rebalancing actually improves your returns over time.

Given that the ratio of investments is often rather arbitrary to begin with, how do I know whether I'm selling high and buying low or just obstinately sticking with a losing asset ratio? Even in the article and answer I cited, the ratios were arbitrary by the writers' own admission (60 - 40 stocks - bonds for the Forbes article, 50 - 50 stocks - bonds for the answer I refer to).

Answer 1

You are very correct, rebalancing is basically selling off winners to buy losers.

Of course the thinking is that selling a winner that has already increased 100% on the basis that it has doubled so it is likely to go down in the near future. However, just look at Apple as an example, if you bought Apple in June 2009 for $20 (adjusted price) and sold it as part of rebalancing when it rose to $40 (adjusted price) in September 2010, you would have missed out on it reaching over $95 2 years later.

Similarly you look to rebalance by buying assets which have been battered (say dropped by 50%) on the basis that it has dropped so much that it should start increasing in the near future. But many times the price can fall even further.

A better method would be to sell your winners when they stop being winners (i.e. their uptrend ends) and replace them with assets that are just starting their winning ways (i.e. their downtrend has ended and are now starting to Uptrend).

This can be achieved by looking at price action and referring to the definitions of an uptrend and a downtrend.

Definition of an uptrend - higher highs and higher lows.

Definition of a downtrend - lower lows and lower highs.

Answer 2

A strategy of rebalancing assumes that the business cycle will continue, that all bull and bear markets end eventually.

Imagine that you maintained a 50% split between a US Treasury bond mutual fund (VUSTX) and an S&P 500 stock mutual fund (VFINX) beginning with a $10,000 investment in each on January 1, 2008, then on the first of each year you rebalanced your portfolio on the first of January (we can pretend the markets are open that day). The following table illustrates the values in each of those funds with the rebalancing transactions:

        Date        Price   Shares   Total
        --------    -----   -------  ----------
VUSTX   1/1/2008    11.76   850.340  $10,000.00
        1/1/2009    12.21   850.340  $10,382.65
                            179.830  $ 2,195.73 - Sell
                            670.510  $ 8,186.92 = New Total
        1/1/2010    11.15   670.510  $ 7,476.19
                            142.202  $ 1,585.55 + Buy
                            812.712  $ 9,061.74 = New Total
        1/1/2011    10.77   812.712  $ 8,753.91
                            273.867  $ 2,949.55 + Buy
                           1086.579  $11,703.46 = New Total 
        1/1/2012    13.32  1086.579  $14,473.23
                             95.002  $ 1,265.42 - Sell
                            991.577  $13,207.81 = New Total
        1/1/2013    12.61   991.577  $12,503.79
                            102.380  $ 1,291.01 + Buy
                           1093.957  $13,794.80 = New Total
        1/1/2014    11.55  1093.957  $12,635.20 
                            163.780  $ 1,891.66 + Buy
                           1257.737  $14,526.86 = New Total
        1/1/2015    14.19  1257.737  $17,847.29
                             55.619  $  789.23 - Sell
                           1202.118  $17,058.06 = New Total
        1/1/2016    12.80  1202.118  $15,387.11
                             46.926  $   600.65 + Buy
                           1249.044  $15,987.76 = New Total
        1/1/2017    11.79  1249.044  $14,726.23

VFINX   1/1/2008    127.02   78.728  $10,000.00
        1/1/2009    76.10    78.728  $ 5,991.20 
                             28.853  $ 2,195.73 + Buy
                            107.581  $ 8,186.93 = New Total
        1/1/2010    98.97   107.581  $10,647.29
                             16.021  $ 1,585.55 - Sell
                            123.602  $ 9,061.74 = New Total
        1/1/2011    118.55  123.602  $14,653.02
                             24.880  $ 2,949.55 - Sell
                             98.722  $11,703.47 = New Total
        1/1/2012    120.97   98.722  $11,942.40
                             10.461  $ 1,265.42 + Buy
                            109.183  $13,207.82 = New Total
        1/1/2013    138.17  109.183  $15,085.82 
                              9.344  $ 1,291.01 - Sell
                             99.839  $13,794.81 = New Total
        1/1/2014    164.45   99.839  $16,418.52
                             11.503  $ 1,891.66 - Sell
                             88.336  $14,526.86 = New Total
        1/1/2015    184.17   88.336  $16,268.84
                              4.285  $   789.23 + Buy
                             92.621  $17,058.07 = New Total
        1/1/2016    179.10   92.621  $16,588.42
                              3.354  $   600.65 - Sell
                             89.267  $15,987.77 = New Total
        1/1/2017    210.46   89.267  $18,787.13

This second table shows what that same money would look like without any rebalancing over those years:

                    Total W/O
Date     Rebalanced Rebalance  VFINX      VUSTX
-------- ---------- ---------- ---------- ----------
1/1/2008 $20,000.00 $20,000.00 $10,000.00 $10,000.00 
1/1/2009 $16,373.85 $16,373.85 $ 5,991.20 $10,382.65
1/1/2010 $18,128.48 $17,272.98 $ 7,791.71 $ 9,481.29
1/1/2011 $23,406.93 $18,491.36 $ 9,333.20 $ 9,158.16
1/1/2012 $26,415.63 $20,850.26 $ 9,523.73 $11,326.53
1/1/2013 $27,589.61 $21,600.64 $10,877.85 $10,722.79
1/1/2014 $29,053.72 $22,768.25 $12,946.82 $ 9,821.43
1/1/2015 $34,116.13 $26,565.66 $14,499.34 $12,066.32
1/1/2016 $31,975.53 $24,984.53 $14,100.18 $10,884.35
1/1/2017 $33,513.36 $26,594.60 $16,569.09 $10,025.51

Obviously this is cherry-picking for the biggest drop we've recently experienced, but even if you skipped 2008 and 2009, the increase for a rebalanced portfolio from 2010-2017 is 85% verses 54% for the portfolio that is not being rebalanced in the same period.

This is also a plenty conservative portfolio. You can see that a 100% stock portfolio dropped 40% in 2008, but the combined portfolio only dropped 18%. A 100% stock portfolio has gained 175% since 2009, compared to 105% for the balanced portfolio, but it's common to trade gains for safety as you get closer to retirement. You didn't ask about a 100% stock portfolio in your initial question.

These results would be repeated in many other portfolio allocations because some asset classes outperform others one year, then underperform the next. You sell after the years it outperforms, then you buy after years that it underperforms.

Answer 3

If you are making regular periodic investments (e.g. each pay period into a 401(k) plan) or via automatic investment scheme in a non-tax-deferred portfolio (e.g. every month, $200 goes automatically from your checking account to your broker or mutual fund house), then one way of rebalancing (over a period of time) is to direct your investment differently into the various accounts you have, with more going into the pile that needs bringing up, and less into the pile that is too high. That way, you can avoid capital gains or losses etc in doing the selling-off of assets. You do, of course, take longer to achieve the balance that you seek, but you do get some of the benefits of dollar-cost averaging.

Answer 4

Also, almost by definition rebalancing involves making more trades than you would have otherwise; wouldn't the additional trading fees you incurred in doing so reduce the benefits of this strategy?

You forgot to mention taxes.

Rebalancing does or rather can incur costs. One way to minimize the costs is to use the parts of the portfolio that have essentially zero cost of moving. These generally are the funds in your retirement accounts. In the United States they can be in IRAs or 401Ks; they can be regular or Roth. Selling winners withing the structure of the plan doesn't trigger capital gains taxes, and many have funds within them that have zero loads.

Another way to reduce trading fees is to only rebalance once a year or once every two years; or by setting a limit on how far out of balance. For example don't rebalance at 61/39 to get back to 60/40 even if it has been two years.

Given that the ratio of investments is often rather arbitrary to begin with, how do I know whether I'm selling high and buying low or just obstinately sticking with a losing asset ratio?

The ratio used in an example or in an article may be arbitrary, but your desired ratio isn't arbitrary. You selected the ratio of your investments based on several criteria: your age, your time horizon, your goals for the money, how comfortable you are with risk. As these change during your investing career those ratios would also morph. But they aren't arbitrary.

These decisions to rebalance are separate from the ones to sell a particular investment. You could sell Computer Company X because of how it is performing, and buy stock in Technology Company Y because you think it has a better chance of growing. That transaction would not be a re-balancing. Selling part of your stock in Domestic Company A to buy stock in international Company B would be part of a re-balancing.