Whether you're a rebalancing expert or an investing newbie, this article is for you! Learn why you should care about rebalancing and how FutureAdvisor rebalances your portfolio.
Over time, your portfolio naturally changes due to market movements. Rebalancing is the act of restoring your portfolio to its target asset allocation. How and why do portfolios change naturally over time? Well, assets that performed well take up more of your portfolio and those that didn’t perform as well take up less. And despite what you may hear on TV, or from your Dad’s golf buddy, there is no crystal ball for the stock market. Instead, the FutureAdvisor Investment Philosophy holds twelve asset classes across many global sectors, therefore capturing returns wherever they may occur. (It is important to remember that while a global portfolio allows for capturing returns, it also means an investor is exposed to losses wherever they occur. Also, in some years, all asset classes may experience a loss.) Rebalancing requires you to sell some of your asset classes that have outperformed in the short term, so you can buy more of the asset classes that have underperformed in the short term. Though this may seem counterintuitive, you’ll soon learn how this concept is at the heart of sound investing.
An example: Rebalancing makes a difference
A $100 portfolio has a target asset allocation of an 85/15 stock/bond split. This portfolio consists of $85 in stocks and $15 in bonds and is pictured in the first pie chart. It is perfectly “balanced.”
Let’s say that throughout the year, stocks return 35% and bonds return 2%. (For illustrative purposes, we are using an exaggerated return for stocks.) Stocks are now worth $114.75 (85 x 1.35) and make up 88.2% of your portfolio, while bonds are worth $15.30 (15 x 1.02) and make up 11.8%. This is pictured in the pie chart labeled “1 Year Later.” You can see how this portfolio isn't balanced in accordance with its target asset allocation. Because it has more stocks than it should, it's taking on excessive risk.
Now, let’s say you go another year without rebalancing. To keep things easy, we’ll stick with the same returns as the year before (the exaggerated 35% for stocks and 2% for bonds). Stocks are now worth $154.91 of your portfolio and bonds a mere $15.61. That means that suddenly your portfolio has drifted significantly from its target with stocks making up 90.8% of the portfolio and bonds only 9.2%. In this example, rebalancing is the act of trimming your stocks and buying more bonds to get back to your target 85/15 stock/bond split.
If you hadn't rebalanced and instead left your portfolio with a 91/9 stock/bond split, you would have been taking on additional, and unnecessary, risk. And in reality, that 85/15 ideal split changes each year you inch closer to retirement. So after two years your new ideal split may be 83/17, instead of 85/15. Remember, as you get closer to retirement, your portfolio should get incrementally more conservative. This is all the more reason rebalancing is important!
Conversely, if both stocks and bonds were to go down, we would buy more of the asset class that has gone down the most, to get you back in line with your target allocation.
Maybe Numbers Aren’t Your Thing: Rebalancing Put Another Way
Meet Farmer John - instead of stocks and bonds, his assets are rabbits and sheep. After much research, he decides his farm’s ideal ratio of rabbits to sheep is 50/50. A year after buying the animals for his farm, Farmer John decides it's time to take inventory. As we all know, rabbits reproduce much faster than sheep, and he now finds himself with a 70/30 ratio of rabbits to sheep. Sheep are an important asset on his farm as their wool is a reliable source of yearly income. He knows that if he does nothing his farm will soon be overrun with rabbits. So on Sunday he takes some of his prized rabbits and sells them at the market. With his profits he buys several additional sheep. His farm is back to his ideal ratio, balance is restored, and Farmer John sighs with relief! He can sleep soundly at night knowing that he has maintained balance on his farm and has also reduced risk in the event something were to happen to one of the species.
***Bonus material: Can you think of another way Farmer John could get back to his ideal 50/50 ratio, without selling off any rabbits?
That’s right, he could simply buy more sheep! Going back to the stock/bond example, instead of selling stocks to buy bonds, you could obtain your ideal split by adding more cash to the portfolio. Our algorithm would use that cash to buy bonds to get you up to 17% bonds (for example).
Advanced takeaway: Rebalancing through contributions is a more tax-efficient way of investing, since you don’t have to sell any stocks, which would create a capital gain. That’s how making regular contributions is one way to improve the tax-efficiency of your portfolio. The algorithm will use the new cash (or dividends paid out) to purchase whatever asset class is needed most to get your asset allocation back to the ideal split. This way, the algorithm doesn’t have to sell the appreciated asset class and incur a capital gain.
“Rebalancing is a disciplined way of buying low and selling high”
The mechanics of rebalancing can be very counterintuitive.
Our instinct tells us to hold on to our high performing assets, and perhaps to even buy more of them! Don't fall for this common investor mistake. It's called “chasing heat” and it's something we help you avoid through automated investing.
You can think of rebalancing as an organized way of helping you buy asset classes at a “discount.” Everyone loves a good sale, and financial instruments should be no different. If it helps, you can think of rebalancing as an organized way to ensure you're taking advantage of sale prices. Bonds allow you to do this by providing stability in your portfolio and by providing something to sell when stock prices drop.
In August 2015, stocks dropped 8% in two weeks. Roughly 21% of our Premium users saw a portfolio rebalance, which was an opportunity to sell bonds and buy stocks while stocks were “cheap.” Many investors are tempted to move their money out of stocks in times like August 2015 because stocks are falling, buying bonds in turn since they're less risky. (This is exactly what drives the price up.) These unfortunate investors are selling low and buying high, just the opposite of smart investing! With disciplined rebalancing in place, Premium clients were able to sell bonds and buy stocks while they were at a discount, all while maintaining the appropriate risk for their situation. Additionally, everything was done automatically -- Premium users didn’t have to do a thing! Having an automatic system in place means it will actually get done, too.
Risk and Return
Another important thing to keep in mind is that the main goal of rebalancing is to reduce volatility in your portfolio, not to increase returns. When you signed up for our automatic portfolio management service, we asked you about your tolerance for risk and your desired retirement age. This allowed us to create a model for your ideal portfolio, which was likely made up of twelve asset classes. With regular rebalancing, we are keeping your portfolio in line with our model. This regular rebalancing helps control the risk in your portfolio and therefore smooths your path to retirement.
When it comes to long-term investment success, sticking to your goals and managing your risk are vital – rebalancing helps you with both!
Inside the Algorithm
FutureAdvisor looks for rebalancing opportunities in your portfolio every trading day.
Our algorithm is checking on your accounts each trading day to make sure you haven't strayed too far from your target asset allocation. We allow some drift so we can capture returns, and always calculate whether the benefit of rebalancing outweighs its costs. We place different priorities on different parts of your portfolio, meaning we don’t allow for as much deviation from your overall stock/bond split and we do the deviation from your foreign vs. emerging market exposure, for example. Also, every new dividend and contribution gets invested in the asset classes that are furthest from their ideal allocations. This continual “mini-rebalancing” helps you avoid the taxes and trading costs that can come with a total portfolio rebalance. On average, your portfolio will likely get rebalanced 4-6 times per year, but that can vary based on market conditions and how often you make regular cash contributions.
FutureAdvisor employs what is known as “market-based rebalancing,” meaning we rebalance your portfolio as needed based on market movements. For example, if your portfolio needs a rebalance in May and then again in June, it will get both. “Calendar-based rebalancing” is a method used by other firms, advisors, and some DIY investors. This means portfolios get rebalanced yearly, or maybe quarterly, if they need it. The difference is unless the market movements happen to coincide with calendar quarters, opportunities to rebalance can be missed. In the above example, the May rebalance would be missed because it fell in the middle of Q2. Market-based rebalancing is a smarter and more efficient way to employ a rebalancing strategy.
Costs of Rebalancing
Our algorithm weighs all the various costs and benefits of rebalancing and decides whether any transactions are warranted to get you closer to your target asset allocation. We always look to minimize all the costs associated with rebalancing. Imagine a human advisor (or yourself) trying to check thousands of client accounts each trading day, looking to see how far each has deviated from its ideal allocation. That would take several hours to do, and in turn, be more expensive for you. Our algorithm can do this in about 10 seconds! Here are some considerations to keep in mind when considering a rebalance:
- Transaction fees: We always look to minimize the number of overall positions, trades, and fees
- Taxes: We employ tax-efficient placement by rebalancing in a tax-sheltered account when possible, and factoring in capital gains when not (capital gains taxes may be due upon the sale if the asset sold has appreciated in value)
- Time and Effort: When done by a DIY investor, or by a human financial advisor, rebalancing takes time and effort, which translates to higher management costs. Because FutureAdvisor efficiently rebalances your portfolio using software, we don’t have to charge additional management fees for each rebalance.
The team at FutureAdvisor aren’t the only ones who love rebalancing. David Swensen, Chief Investment Officer for the Yale University Endowment, and author of “Unconventional Success,” has described rebalancing in the following ways:
- “Rebalancing represents extremely rational behavior”
- “Rebalancing forces investors to act against the crowd”
- “...shunning the loved and embracing the unloved. Most people do the opposite”
- “…contrarian behavior lies at the heart of most successful investing programs”
In closing, rebalancing helps keep the risk of your portfolio appropriate and helps you achieve your long-term financial goals. Our algorithm is monitoring your portfolio for opportunities to rebalance every trading day, but only does so when the benefits outweigh the costs. When it is time to rebalance, the algorithm does so in the most efficient manner possible.
Disclaimer: The views expressed are for informational purposes only and are not intended to serve as a forecast, a guarantee of future results, investment recommendations or an offer to buy or sell securities by FutureAdvisor. All expressions of opinion are subject to change without notice in reaction to shifting market, economic, or political conditions. The investment strategies mentioned are not personalized to your financial circumstances or investment objectives, and differences in account size, the timing of transactions and market conditions prevailing at the time of investment may lead to different results. Clients may lose money. Past performance is not indicative of future results. Investments in securities involve the risk of loss. Any tax strategies discussed should not be interpreted as tax advice and do not represent in any manner that the tax consequences detailed will be obtained. Clients should consult with their personal tax advisors regarding the tax consequences of investing.