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Q I started investing with the Couch Potato strategy two years ago. My question is about restoring balance. Would it be better or worse if the balance was restored monthly instead of once a year? I like to be a hands-on investor and wouldn’t mind the extra time it would take as long as there was a chance for a little bit of growth in returns over 10 years or more. – Santa Claus
AND. Even the Couch Potato strategy requires little maintenance. Your asset allocation – that is, the target percentage of stocks and bonds in your portfolio – will change as markets change. Therefore, from time to time you may need to sell some assets that have appreciated and use the proceeds to cover arrears. For example, after a sharp decline in stock markets, you can sell some of your bonds and use the cash to buy more shares. This is called rebalancing and is an important part of any disciplined investing process.
That said, rebalancing is often misunderstood. Its goal is not to increase profits; rather, it is primarily a risk management tool. Moreover, rebalancing always comes with a trade-off: it often involves transaction costs and taxes, so rebalancing too often can be counterproductive.
Let’s unpack these ideas a bit. Remember that over the long term, stocks have a much higher expected return than bonds. So in most periods, rebalancing will be a matter of selling stocks and buying bonds, not the other way around. For this reason, a rebalancing of the stock and bond portfolio is likely lower your profits, not increase them.
That said, a slight increase in returns can be expected when reweighting asset classes that have similar expected returns, such as equities from different countries. By selling high occasionally and buying low, there is a potential “rebalancing premium.” But even that will likely be modest.
To test this, I ran data for a portfolio containing equal amounts of Canadian, US and international stocks (all in Canadian dollars) from 1980 to the end of April 2019. It turns out that if we rebalance this portfolio once a year, its annual rate of return for the entire period amounted to 10.4%. What if you haven’t balanced it at all? Exactly the same. (That shocked me too.)
If we just look at the last 10 years (ending April 2019), the annual rebalancing of an all-stock portfolio actually lowered performance because U.S. stocks have consistently outperformed Canadian and international companies, so you would enjoy higher returns if you he just let them run.
So if rebalancing shouldn’t be expected to increase profits – and if it sometimes reduces them – why do it at all? The answer is that portfolio rebalancing is primarily intended to control risk. If you have a carefully crafted plan that includes a portfolio of, say, 60% stocks and 40% bonds, you shouldn’t stray too far from these goals. If your portfolio drops to 70% or 75% stocks, it will be much riskier than before, so the sensible thing to do is sell some stocks and buy some bonds to reduce this risk.
So I hope it’s clear why monthly rebalancing is far too common. In most cases, once a year is enough. Even then, there is no need to rebalance if your portfolio is only slightly skewed. As a general rule, rebalancing should only be considered if any asset class differs from the target by more than five percentage points. So if your goal is 40% bonds, you’ll probably be fine as long as you stay in the 35% to 45% range. This is especially true if your portfolio is relatively small: for example, if you invested $50,000, each percentage point is just $500, which will not have a significant impact in terms of risk or return potential. Once your portfolio is very large, you may argue for more frequent rebalancing.
If you contribute to your portfolio regularly, you can use this cash flow to keep your portfolio balanced. Whenever you add new money, simply buy the asset that is furthest below your target value. In a year where, for example, US stocks have risen significantly and bonds have fallen, simply direct your new contributions to bonds. During a bear market, when stocks are likely to fall below your target level, use this new money to buy more shares. You’ll never keep your portfolio in perfect balance this way, but it’s not necessary. Restoring balance is like playing horseshoes: close is enough.
Dan Bortolotti, CFP, CIM, is an associate portfolio manager and financial planner at PWL Capital in Toronto.
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