Embracing a disciplined approach to rebalancing can lead to better long-term investment outcomes — yet some investors would rather sit in traffic than spend time rebalancing their portfolios.
A new article from Research Affiliates called “Rebalance or Rush Hour?” examines how advisors can help investors overcome a natural tendency to wait and see before repositioning their portfolios.
According to a recent Wells Fargo/Gallup Survey, 31% of investors would opt to spend an hour stuck in traffic rather than spend that time rebalancing their portfolios.
“Why would we subject ourselves to gridlock instead of performing a simple task such as rebalancing a portfolio?” the article asks, and then tries to answer this question too.
The article guesses that for many investors rebalancing could feel worse than rush hour.
“When we’re stuck in traffic, at the very least we’re in the comfort of our cars and can find other productive ways to pass the time, such as listening to the radio, podcasts, or audiobooks,” the article states. “In contrast, rebalancing forces us to endure the discomfort of buying assets that have just inflicted pain from underperformance and of selling recent winning assets.”
The article also states that rebalancing portfolios may also induce additional pain if momentum carries prices further from fair value. And, unlike on the highway, no GPS is available to pinpoint when market cycles will end. According to the article, “fair value may take months, years, and sometimes even decades to assert itself.”
To overcome some of this hesitation with rebalancing, the article suggests keeping the destination in the forefront.
“Because rebalancing our portfolios may induce pain, and even punish us with short-term losses, it becomes even more crucial to keep the end destination — to increase the likelihood of our achieving better investment outcomes over time — forefront in our minds,” the article states.
Rebalancing allows an investor to maintain the desired risk exposure of a portfolio over its life.
As the article points out, the expected volatility of a portfolio with an initial 60/40 allocation to stocks and bonds will change if a bull market in equities has pushed its asset mix to 80/20.
As of June 30, a 60/40 portfolio has an expected volatility of 8.6% compared with 11.4% for an 80/20 portfolio — a 30% increase in volatility, according to the Research Affiliates Asset Allocation Interactive tool.
“By regularly rebalancing portfolios, investors can maintain an exposure to risk that matches their tolerance,” the article states.
Along with reliably reducing risk, rebalancing also has the potential to increase return, according to the article.
“Over the long run, a rebalanced mix delivers better risk-adjusted returns compared to an asset allocation that merely drifts with price movements,” the article states.
According to the article, the benefits of rebalancing arise from “opportunistically capitalizing” on human behavioral tendencies and from long-horizon mean reversion in asset class prices.
So how can advisors help their clients understand the importance of systematically rebalancing their portfolios and adopt it as part of their investing approach?
According to the article, the first step is recognizing humans’ natural behavioral tendencies. The next step is to take a proactive approach, such as applying rules-based rebalancing devoid of emotion and subjectivity can vastly improve investing outcomes.
“[A]dvisors and their clients may be best served by formalizing a rebalancing framework and ‘institutionalizing contrarian investment behavior’ to maximize the odds of reaping the proven benefits of portfolio rebalancing,” the article concludes.
This article by Brent Leadbetter, John West and Amie Ko is part of a series from Research Affiliates that focuses on the investment role of financial advisors.