Many financial advisors recommend re-balancing your portfolio no less often than annually to ensure the asset allocation is consistent with your risk tolerance, as illustrated in this post from Schwab. In the past, I haven’t been one to re-balance my portfolio, so I spent some time thinking about why I haven’t followed this common advice. Up until recently, almost all of my invested assets have been equities, equity-based mutual funds or exchange-traded funds (ETFs). As such, I didn’t need to do any re-balancing across asset classes.

In this post, I’ll explain re-balancing, its specific purpose and examples of its benefits and drawbacks. I’ll also explain my strategy (which may or may not be right for you).

What is Re-balancing?

Re-balancing is the process of buying and selling securities in your portfolio to meet certain targets. In the case of asset classes, the primary purpose of re-balancing is to maintain your target risk/reward balance.

Some people have targets that define their desired allocation across asset classes. One common rule of thumb is that the portion of your portfolio that should be in bonds is equal to your age with the rest in stocks. In my case, that would mean roughly 60% of my portfolio in bonds and 40% in stocks. The goal of this rule of thumb is to decrease the volatility of your investment returns as you get older and closer to that age at which you need to draw down your assets in retirement.

How Does Re-balancing Work?

The process of re-balancing is fairly simple. Periodically, such as once or twice a year, you compare the market value of your investments with your targets. If there is a significant difference between how much you own in an asset class and your target percentage, you sell the portion of your investments that is above the target and reinvest the proceeds in something different.

Let’s say your target is 75% stocks and 25% bonds. You start the year with $10,000 of investments - $7,500 in stocks and $2,500 in bonds. If stocks go up by 10% and bonds go up by 5%, your year-end balances will be $8,250 in stocks and $2,625 in bonds, for a total of $10,875. Your targets though are $8,156 of stocks (75% of $10,875) and $2,719 of bonds. To put your portfolio back in balance, you would need to sell $94 (= $8,250 - $8,156) of stocks and buy $94 of bonds.

You can avoid selling any assets if you have money to add to your investments at the end of the year. Continuing the example, let’s say you have another $500 available to invest at the end of the year. That brings your total available for investment to $11,375 (= $10,875 of investments plus $500 cash). Your targets would be $8,531 (= 75% of $10,875) for stocks and $2,843 for bonds. In this case, you would buy $281 of stocks and $219 of bonds to meet your targets, eliminating the need to sell any of your assets.

What Does Asset Allocation Do?

The chart below compares the average annual returns and risk profiles of several sample portfolios with different mixes between stocks and bonds.

In the middle four portfolios, the first number is the percentage of the portfolio invested in stocks and the second number is the percentage in bonds.

Average Returns

In this chart, the average annual return is represented by the blue dash. When the blue dash is higher on the chart, it means that the returns on the portfolio were higher, on average, over the historical time period.

Volatility

The green boxes correspond to the ranges between the 25th percentile and the 75th percentile. The whiskers (lines sticking out of the boxes) correspond to the ranges from the 5th percentile to the 95th percentile. When the box is tall and/or the whiskers are long, there is a lot of volatility. In this case, it means that the annual return on the portfolio varied a lot from one year to the next. At the opposite end of the spectrum, when the box and whiskers are all short, the range of returns observed historically was more consistent.

Comparison of Portfolios

I have arranged the portfolios so that the one with the most volatility – 100% in the S&P 500 – is on the left and the one with the least volatility – 100% in bonds as measured by the Fidelity Investment Grade Bond Fund (FBNDX) – is on the right. You can see how adding bonds to the S&P 500 reduces volatility as the height of the boxes and whiskers gets smaller as you move from left to right. At the same time, the average annual returns decrease as bonds are added to the portfolio. Over the time period studied (1980 to 2019), the S&P 500 had an average annual return of 8.7% while the Bond Fund had an average annual return of 7.2%. By comparison, returns on investment grade bonds are currently generally less than 4%.

Another Perspective

Because stocks and bonds are not 100% correlated, the volatility (spread between tops and bottoms of boxes and whiskers) of owning a combination of both is less than the volatility of owning just the riskier asset – stocks. As I was preparing the chart above, I noticed, though, that the bottom whisker for the 100% bonds portfolio goes lower than the bottom whisker for the 80% bonds portfolio.

Specifically, there were more negative returns in the historical data (i.e., more years in which you would have lost money in a single year) if you owned just bonds than if you owned the portfolio with 80% bonds and 20% stocks. The 80% bond portfolio had a negative return only 7.5% of the time while the 100% bonds portfolio had a negative return 10% of the time! As more bonds are added to each portfolio, the blue bar/average moves down. This downward shift actually moves the whole box and the whiskers down.

This relationship can be seen in the chart below.

The dots correspond to the portfolios in the previous chart with labels indicating the percentages of stocks in the portfolios. The horizontal or x-axis on this chart represents the average annual return. Values to the right correspond to higher average annual returns (which is good). The vertical or y-axis represents the percentage of years with a negative return. Values that are higher on the chart correspond to portfolios with more years with negative returns (which is bad).

Optimal Portfolios

“Optimal” portfolios are those that are to the right (higher return) and/or lower (fewer years with negative returns). Any time a point is further to the right and at the same level or lower than another one, that portfolio better meets your objectives if probability of having a negative return is your risk metric.

More Stocks Can Be Less Risky

I have circled two pairs of dots. The ones in the lower left corner are the two I’ve mentioned above. The 20% stocks (80% bonds) point is lower than and to the right of the 0% stocks (100% bonds) point. As you’ll recall, the average return on the 20% stocks portfolio is higher than the average return on the all-bond portfolio so the dot is to the right (better). The percentage of the time that the annual return was less than zero was smaller for the 20% stocks portfolio so the dot is lower (also better).

There is a somewhat similar relationship between the 60% and 80% stocks portfolios (circled in green in the upper right). The 80% stocks point is at the same level and to the right of the 60% stocks point. As such, if average annual return and probability of a negative return are important metrics to you, moving from 80% to 60% stocks or 20% to 0% stocks would put you in a worse position as you would have less return for the same risk.

Re-balancing Can't Be Done Blindly

Setting a target asset allocation, such as 80% stocks and 20% bonds, allows you to target a risk/reward mix that meets with your financial goals. As I indicated, the purpose of re-balancing is to ensure that your portfolio is consistent with your goals. However, it is important that you considering the then-current economic environment when re-balancing.

Interest Rates

For example, interest rates are lower than they were at any point in the historical period used in the analysis above. Over the next several years, interest rates are unlikely to decrease much further, but could stay flat or increase. If interest rates stay flat, the returns on bond funds will tend to approach the average coupon rate of bonds which is in the 1% to 3% range depending on the quality and time to maturity of the bonds held. This range is much lower than the average annual return of 7.2% in the illustrations above.

If interest rates go up, the market price of bonds will go down, lowering returns even further. As such, the risk-reward characteristics of bonds change over time. I would characterize them as having lower returns and higher risk (the one-sided risk that prices will go down as interest rates go up) now than over the past 40 years.

Stock Prices

Similarly, the S&P 500 is currently close to or at its highest level ever in a period of significant economic and political uncertainty. While I don’t have a strong opinion on the likely average annual returns on the S&P 500 in the next few years, I think it is likely to be more volatile in both directions than it has in the recent past.

If you re-balance your portfolio, you will want to form your own opinions about the average returns and volatility of the asset classes in which you invest. With these opinions, you can decide whether the asset allocation you’ve held historically will still provide you with the risk/reward profile you are seeking.

Re-balancing and Income Taxes

Another consideration when you are deciding whether and how often to re-balance your portfolio is income taxes. Every time you sell a security in a taxable account, you pay income taxes on any capital gains. If you lose money on a security, the loss can offset other capital gains. On the other hand, if you own the securities in a tax-free (Roth or TFSA) or tax-deferred (traditional or RRSP) account, re-balancing has no impact on your taxes.

Re-balancing Example

Let’s look at an example of the taxable account situation. If you targeted a portfolio of 60% stocks (in an S&P 500 index fund) and 40% bonds (in FBNDX) from 1980 through 2019, you would have made the transactions shown in the chart below.

In this chart, the bars represent the amount of the transaction as a percentage of the amount of stocks held at the beginning of the year. A bar that goes above zero indicates that you would have bought stocks in that year. A bar that goes below zero indicates that you would have sold stocks in the year. The proceeds from every sale would have been used to purchase the bond fund. Similarly, the money used to purchase stocks would come from a corresponding sale of the bond fund.

In every year, you either sell some of the stock index fund or the bond fund. The difference between the price at which you sell a security and the price at which you buy it is called a capital gain. You pay income taxes on the amount of capital gains when they are positive. In the US, many people pay a Federal tax rate of 15% on capital gains in addition to any state income taxes. The Canadian tax rate on capital gains is of about the same order of magnitude.

Reduction in Return from Income Taxes

Income taxes, assuming a 15% tax rate, would have reduced your annual average return from 8.4% to 8.1% over the 1980-2019 time period. Put in dollar terms, you would have had just under $250,000 at the end of 2019 if you started with $10,000 in 1980 and used this asset allocation strategy if you didn’t have to pay income taxes. By comparison, you would have had about $220,000 if you had to pay income taxes on the capital gains, or 12% less.

As you consider whether re-balancing is an important component of your financial plan, you’ll want to make sure you understand the impact of any income taxes on your investments returns.

Why Only Equities?

You may have been wondering why I was invested almost solely in equities for all of my working life and not in a combination of asset classes, such as stocks and bonds. My philosophy was that I preferred to use time to provide a diversification benefit rather than an array of asset classes. By keeping my invested assets in stocks, I was able to take advantage of the higher expected returns from stocks as compared to bonds.

The chart below helps to illustrate this perspective.

It compares the volatility of the annual return on a portfolio of 100% stocks over a one-year time period with the same portfolio over five years and with a portfolio of 60% stocks and 40% bonds over one year.

The blue bars on the first and second bars (100% stocks for one year and five years, respectively) are at the same level, meaning they had the same average annual return. Both the box and whiskers on the second bar are much more compact than the first bar, indicating that the annual returns fell in a much narrow range when considered on a five-year basis rather than a one-year basis.

Cost-Benefit Comparison

Comparison of the first and third bars highlights the cost and benefits of diversifying across asset classes. The box and whiskers on the 60/40 portfolio are both shorter than the 100% stock portfolio. That is, there was less variation from year-to-year in the annual return for the 60/40 portfolio than the 100% stock portfolio. However, the average return (blue line) on the 60/40 portfolio is a bit lower because the 60/40 portfolio had an average annual return that was less than the 100% stock portfolio.

My Focus

The comparison on which I focused in selecting my investment strategy is the one between the second and third bars. That is, I compared the volatility and average returns of a 100% stock portfolio over five years with the volatility and average returns of a 60/40 portfolio over one year. As can be seen, there has been less volatility in annual stock returns when considered in five-year time periods. Yet, the average return on stocks is higher than the average return on the blended portfolio. Because I didn’t anticipate that I would need to draw down my investment portfolio, I was willing to look at risk over longer time periods and tolerate the year-to-year fluctuations in stock prices in order to expect higher investment returns.

Your time horizon until you might need the money in your investment portfolio and your willingness to wait out the ups and downs of the stock market are important considerations as you decide whether this strategy or a more traditional blended portfolio is a better fit for you.

Sep 15 Why I Chose Patience over Re-balancing