April 17, 2014

Asset Allocation Rebalancing

Asset Allocation Rebalancing StrategyOne of the cornerstones of asset allocation is the concept of rebalancing.  Done correctly, rebalancing forces you to buy certain investments when they are undervalued (cheap) and sell when they are overvalued (expensive).  In effect, it makes the owner of the portfolio a value investor without the need to analyze individual companies.  It can even be taken one step further with something known as tactical asset allocation.

How Rebalancing Supports Your Asset Allocation Strategy

Once you’ve chosen an asset allocation model portfolio, you will find that as time goes on, your asset class balance will naturally come undone.  If real estate falls as bond values rise, you would end up owning far more bonds than real estate, which is not part of your overall asset allocation strategy.  The experts created the rebalancing strategy as a solution designed to help you achieve your financial goals and objectives.  In effect, rebalancing forces you to buy low and sell high.  Here’s how it would work.

Imagine that you have a portfolio with a $100,000 market value.  You follow the Benjamin Graham asset allocation model and begin by putting 50% of your money, or $50,000, in stocks, with the remaining 50% put into bonds.  You select the Dow Jones Industrial Average iShares (Ticker Symbol IYY) and the Vanguard Intermediate Term Bond ETF (Ticker Symbol BIV).

At the end of the year, your bond holdings have appreciated by 5%, bringing the value of your bond component to $52,500.  Your stock holdings appreciated 11%, bringing the value to $55,500.  Your combined portfolio value is now $108,000.  Your asset allocation exposure now consists of 48.611% bonds and 51.139% stocks.  You can see how, over time, your asset allocation could drift far away from your intended asset class exposure.

Rebalancing would require you to reset your portfolio value to 50% stocks and 50% bonds.  In this case, your portfolio has a market value of $108,000 so you’d need $54,000 in stocks and $54,000 in bonds.  That means you would sell $1,500 of the Dow Jones ETF and buy $1,500 of the bond ETF.  If stocks are experiencing a bubble as asset prices rise, you are now somewhat protected by maintaining your target asset allocation mix.  However, you are still prospering from a rise in the market because you own more stock in an absolute sense.  Remember, you started the year with $50,000 in stock and ended it with $54,000 in stock.  You own $4,000 more worth of the Dow Jones ETF than you did.

Is Asset Allocation Rebalancing Cutting the Flowers and Watering the Weeds?

Famed mutual fund manager Peter Lynch once called selling winners to buy losers “cutting the flowers and watering the weeds”.  In one sense, he is correct.  Asset allocation investors, on the other hand, are those that would like to avoid having to select individual investments and spend all of their free time pouring over financial statements and reading 10K disclosure documents.  It’s true that those who bought Coca-Cola, or Wal-Mart Stores, or Home Depot, or Berkshire Hathaway would have missed out on millions of dollars in profit if they had used rebalancing as part of their asset allocation strategy.  They still would have ended up rich, though.  Had they been one of the unlucky ones that owned Worldcom, or Enron, or Lehman Brothers, or AIG.

The bottom line is, only you and your advisor can decide what is right for your financial situation, needs, and risk tolerance.  Whether you are willing to risk parting with some of the upside in exchange for insurance against total loss is a decision you need to make for yourself.