Rebalance to ensure you sell high, buy low

Reducing strong performers locks in their gains and allows you to move funds to restore your original asset allocation

23 Jul 2012 15:13 by AMITAVA NEOGI
Morgan Stanley Private Wealth Management, India

WE all know that the “buy-and-hold” strategy is not always effective. While it is not advisable to time markets, there is merit in monitoring performance. After all, it is your wealth and it pays to be disciplined about your investments.
 
What is rebalancing?
Your portfolio is constantly changing because you have invested in markets that change daily. Over time, some of your investments are going to outperform others, resulting in their greater weightage in your portfolio. This exposes you to greater risk and losses if such investments underperform. Rebalancing is the process of buying and selling portions of your portfolio to ensure that over time it is not materially different from your risk-return profile.

Stick with your plan: Buy low and sell high
All asset classes go through cycles. Most investors aren’t lucky to invest at the lows and exit at the highs. Investors are consumed by fear when markets fall and become greedy when markets rise. Reducing strong performers to restore balance, forces you to “Buy Low and Sell High”, something all investors say they want to do but rarely implement.

When to consider rebalancing
Many believe that stars will continue to outperform in the future. Past performance is no guarantee of future performance. Towards the end of the dotcom bubble in the late 1990s, those who ignored their portfolios were severely overweight in these sectors. Rebalancing would have locked in gains and protected their portfolios from the sharp fall when the bubble burst in 2000.

Rebalancing is not about timing the market; instead it is about monitoring your investments and making adjustments to ensure that they are in line with your goals. As a rule of thumb, you should not rebalance unless there is 10%+ deviation from your original asset allocation or if your risk profile has changed.

Broadly, there are two ways to rebalance your portfolio:
>Sell overweight categories and use the proceeds to purchase underweight categories.
>Use fresh funds, systematic contributions to purchase underweight categories, thereby achieving desired allocation, growing your portfolio, minimising costs and taxes.

You can rebalance your portfolio either on calendar or weightage basis. Many recommend rebalancing at regular intervals such as annually. Others recommend rebalancing only when the relative weight of an asset class changes more than a certain percentage. Regardless of which trigger you choose, you shouldn’t rebalance too often, or else you may incur higher costs and taxes.

A buy-and-hold strategy would have been ineffective during 2007-2012 period. We learnt to realise profits in 2007 when the markets peaked. 2008’s lesson was capital preservation, while 2009 taught us not to be bearish in the face of massive monetary stimulus. 2010’s lesson was how to handle post-stimulus market swings. 2011 offered limited choice for regular income due to near all-time low interest rates. This year is dominated by market volatility resulting from the European debt crises and slower global recovery.

Let’s consider a simple example. Say your portfolio of $1 million was invested 50 per cent in the S&P 500 and 50 per cent in a bond fund but due to the phenomenal rise in the S&P 500 before the 2008 crash, it had become 70-30. In early 2008, you rebalanced your portfolio back to 50 per cent S&P 500 and 50 per cent the bond fund.

Your rebalanced portfolio would have lost 17.25 per cent by the end of 2008, as the S&P 500 was down 38.5 per cent and the bond fund was up 4 per cent that year (($500,000 x 61.5 per cent + $500,000 x 104 per cent = $827,500)/$1,000,000).

If your strategy was buy and hold and therefore you didn’t rebalance in early 2008, your portfolio would have lost 25.75 per cent (($700,000 x 61.5 per cent + $300,000 x 104 per cent = $742,500)/$1,000,000) by year-end.

At the end of 2009, during which the S&P 500 was up 23.5 per cent and the bond fund was up 3 per cent, your rebalanced 50:50 portfolio would have been valued at $937,144 ($413,750 x 123.5 per cent + $413,750 x 103 per cent).

The buy-and-hold portfolio would, however, have been lower at $853,028 ($700,000 x 61.5 per cent x 123.5 per cent + $300,000 x 104 per cent x 103 per cent).

When you rebalance, you realise profits and sell high and buy low. In the above example, the S&P 500 had significantly outperformed bonds pre-2008 correction, so to rebalance you periodically realised gains in the S&P 500 and invested the proceeds in bonds, thereby locking in some of your profits.

In 2008, when the S&P 500 underperformed, you had lesser exposure to the S&P 500 and more to bonds, resulting in a better overall performance.

Additionally, if your goals change, you need to rebalance. For example, if you are 10 years from retirement, you may consider moving a portion of the portfolio into an income-oriented allocation annually, so that when you retire, your portfolio will reflect your new goals.

To conclude, as with many portfolio-hedging strategies, your upside potential may be limited, but by rebalancing you will adhere to your goals, regardless of what the market does.