If there is a universal investment ideal, it is this: You want to buy low and sell high.
What if I told you that there was a process for automatically doing just that? You’d rush to use it, wouldn’t you? Guess what – there is. To use industry jargon, it is called “rebalancing.”
To properly describe what rebalancing actually is, we have to take a step back and look at how you can reach your financial goals by applying this simple and effective approach.
Rebalancing occurs in the “investments that fit your plan” section, which to use a bit more industry jargon is really the process of creating and maintaining an Investment Policy Statement (IPS).
Any properly crafted IPS will have defined allocations to various asset classes, like stocks or bonds. As financial markets shift around, your investments tend to stray from their original, intended “weights” or allocations. Rebalancing is the act of shifting those allocations back to where they belong.
To illustrate, imagine your portfolio is supposed to be half stocks and half bonds. When the stock market outperforms the bond market, you end up with too many stocks relative to bonds. Or of course the reverse can happen. Either way, you’re no longer at your intended 50/50 mix. To rebalance your portfolio, we can sell some of the now-overweight assets, and use the proceeds to buy assets that have become underrepresented, until you’re back at or near your desired mix.
Did you catch what just happened? Not only are we keeping your portfolio on track toward your goals, but we’ve just bought low and sold high. Better yet, the trades were not a matter of fancy guesswork or emotional whims. The feat was accomplished according to your carefully crafted, customized plan.
Portfolio balancing: a closer look
Rebalancing is a little more complicated, in that it’s a plural versus singular activity. First, we build a balance between stocks versus bonds, reflecting your need to take on market risk in exchange for expected returns. We enhance expected returns by having greater exposure to factors such as company size, relative value and expected profitability. Finally, all of our portfolios are globally diversified to reduce risk.
The reason for having relatively precise allocations to various asset classes and factor exposures is to give you the right amount of expected return to meet your personal financial goals, while lowering risk by broad diversification.
At first glance, rebalancing seems counter-productive. Why sell a portion of an outperforming investment only to acquire a larger share of an underperforming one? Intuition might suggest that selling previous winners may hinder returns in the future. This logic is flawed, however, since past performance may not continue in the future—and there’s no reliable way to predict future returns.
Equally important, remember that you chose your original asset allocation to support your long-term financial goals. Rebalancing realigns your portfolio to these priorities by using structure, not recent performance, to drive investment decisions.
Rebalancing is scary to do in real time.
Everyone understands the logic of buying low and selling high. But when it’s time to rebalance, your emotions make it easier said than done. This is why it is extremely important to rely on rules and procedures, rather than will power alone. To illustrate, consider a couple of real-life scenarios.
- When times are bad: Bad times in the market can represent good times for rebalancing. But that means you must sell some of your assets that have been doing okay and buy the unpopular ones. The Great Recession of 2007–2009 is the quintessential example. To rebalance then, you had to sell some of your safe-harbor holdings and buy stocks, even as popular opinion was screaming that stocks were dead. Of course history has shown otherwise; those who did rebalance were well positioned to capture available returns during the subsequent recovery. But at the time, it represented a huge leap of faith in the academic evidence indicating that our capital markets were expected to prevail.
- When times are good. An exuberant market can be another rebalancing opportunity – and another challenge, as you must sell some of your high-flyers (selling high) and rebalance into the lonesome losers (buying low). At the time, this feels counterintuitive. But those who rode the 1990s dot-com wave through its crest can understand why it’s a good idea to periodically shift some of your captured returns to safer grounds.
Costs must be considered.
Besides combatting your emotions, there are practical concerns. If trading were free, we could rebalance your portfolio every day with absolute precision. In reality, trading incurs transaction fees as well as potential tax liabilities. To help us achieve a reasonable, middle ground, the following strategies can help minimize the impact:
- Rebalance with new cash. Rather than selling over-weighted assets that have appreciated, use new cash to buy more under-weighted assets. This reduces transaction costs and the tax consequences of selling assets.
- Whenever possible, rebalance in tax-deferred (RRSPs/RRIF) or tax-free (TFSA) accounts where capital gains are not taxable.
- Incorporate tax management within taxable accounts, such as cost base management, strategic loss harvesting, dividend management, gain/loss matching.
- Implement an integrated portfolio strategy instead of maintaining rigid barriers between component asset classes and accounts – in other words, manage the portfolio as a whole.
The Rebalancing Take-Home
Rebalancing makes sense once you understand the basics: It gives you a clear, evidence-based process for staying on course toward your personal financial goals through good and bad times.