Portfolio Rebalancing for the Timid

While rebalancing in a pure form will do a better job of controlling risk, these strategies can help add a contrarian tilt to a portfolio

Christine Benz 30 March, 2015 | 11:30AM
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The audience who had turned out for my session on retirement planning looked at me like I had three heads.

After all, I had just shown them a slide depicting miserly yields on high-quality bonds—2% or lower, in most cases. I had also discussed how to do a "duration stress test" of their bond holdings; my example featured a long-term government bond that would likely experience a double-digit drop if rates jumped up by one percentage point.

So, why on earth would I suggest that they rebalance their portfolios into...gulp...bonds?

Risk control is the key reason. While rebalancing a portfolio won't necessarily enhance a portfolio's return, most studies on the topic demonstrate that investors can reduce their portfolios' future volatility levels by scaling back on highly appreciated asset classes and adding to the losing ones. And limiting volatility—and avoiding "sequencing risk" (that is, encountering lousy returns in the early retirement years)—should be at the front of retirees’ minds.

However, rebalancing can be psychologically difficult. It seems counterintuitive to trim the best-performing securities in a portfolio; one might logically assume that they've got the right stuff and will keep on winning. Moreover, the winners in a portfolio often appear to have a macroeconomic tailwind. Just think of US stocks right now. The US economy has been steadily improving and shows no imminent signs of slowing down, so trimming them might look like a mistake.

Meanwhile, it's hard to imagine that the securities that haven't performed as well in a portfolio—the ones that rebalancing would have you buying—will ever be worthwhile. Take bonds, for example. Given the prospect of rising rates and today's ultralow yields, it's difficult to see why one would want them in a portfolio at all, let alone add to them.

What follows are three possible strategies for investors who can't bring themselves to go "all-in" on rebalancing but want to capture some of its risk-reducing benefits. Investors who take these routes rather than pursuing rebalancing in its pure form will, however, want to bear in mind that the chicken methods won't yield the same risk-reduction benefits. Thus, these strategies—especially the first two—will tend to be the best fit for those with longer time horizons and/or higher risk tolerances.

1) Redirect New Contributions

In addition to the psychological impediments of rebalancing, parting with a portfolio's most winning securities can entail costs, both transaction costs and capital gains taxes if the investor rebalances in a taxable account. One way to circumvent those expenses while picking up on at least some of the beneficial effects of rebalancing is to skip the selling piece and instead use future contributions to help restore balance. Right now, for example, investors who would like to give their portfolios a contrarian tilt might curtail new purchases of US equity holdings and instead direct new contributions to bonds, emerging markets equities and cash. 

Because it works very gradually, such a strategy will tend to be less beneficial from the standpoint of risk reduction than will traditional rebalancing—selling winners and buying losers all in one go. If US stocks sell off sharply, the investor who fully rebalanced will be in better shape than the one who isn't directing new contributions to US equities but hasn't trimmed the highly appreciated asset class, either. In addition, this tack will tend to be the most impactful for those investors who are fairly early in their investment careers; their new contributions will naturally account for a larger percentage of their balances than is the case for investors with very large portfolios. For investors with larger balances, true rebalancing—both selling winners and buying losers—remains the best way to reduce volatility in their portfolios going forward. 

2) Practice Intra-Asset-Class Rebalancing

Another idea for investors who can't get excited about true rebalancing is to leave the portfolio's baseline asset allocations intact and, instead, make adjustments within asset classes. While the performance of securities within a given asset class may be directionally the same over long periods, there may be significant variations in performance.

For example, an investor who has seen his allocation to stocks drift up to 70%—away from his 60% target—may want to leave that baseline allocation alone but change things under the bonnet. That way, the investor can at least scale back on areas that may be notably overvalued while adding to potentially undervalued categories.

Within the US equity space, for example, growth stocks have generally outperformed value names since stocks began rallying six years ago and could, therefore, be hit harder in an eventual sell-off; de-emphasising the former and adding to the latter is a way to take at least some risk off the table. Adding to international stocks, especially emerging markets, at the expense of US is another way to add a contrarian tilt to a portfolio. Within the fixed-income space, an investor might reasonably trim higher-risk bond types that have outperformed—long duration and high yield, for example—while topping up exposures in shorter-term, high-quality bonds and inflation-linked bonds.

As with the previous strategy, investors won't gain a lot of protection against a sharp sell-off: When equities fall, they tend to fall across the board. (The dot-com sell-off was an exception; small-cap value stocks actually rose while large-growth stocks took a beating.)

3) Delegate

Investors uncomfortable with doing the heavy lifting of shifting their portfolios around could reasonably delegate some of that work. Target-date funds, for example, involve built-in rebalancing and a gradual shift towards a more conservative portfolio mix. Many pension plans also allow contributors to choose an automatic rebalancing feature, whereby the portfolio's asset-class exposures are periodically restored to their target level.

Alternatively, investors could steer a component of their portfolios to a valuation-conscious fund with wide leeway to seek out the most attractively valued asset classes at any point in time. A word of warning, however; there are very few genuine value funds available to UK-based investors. Of those available, one could consider Investec Cautious Managed, which Morningstar Analysts rate Silver; Artemis Strategic Assets, which is not rated by Morningstar analysts but carries a 2-star past performance rating; or M&G Episode Growth; which Morningstar Analysts rate Neutral.

This article has been amended for a UK audience.

The information contained within is for educational and informational purposes ONLY. It is not intended nor should it be considered an invitation or inducement to buy or sell a security or securities noted within nor should it be viewed as a communication intended to persuade or incite you to buy or sell security or securities noted within. Any commentary provided is the opinion of the author and should not be considered a personalised recommendation. The information contained within should not be a person's sole basis for making an investment decision. Please contact your financial professional before making an investment decision.

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Securities Mentioned in Article

Security NamePriceChange (%)Morningstar
Artemis Strategic Assets R Acc0.91 GBP0.12Rating
M&G Episode Growth GBP A Inc  
Ninety One Global Income Opports A Acc388.49 GBP-0.12Rating

About Author

Christine Benz

Christine Benz  is director of personal finance at Morningstar and author of 30-Minute Money Solutions: A Step-by-Step Guide to Managing Your Finances.

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