The rebalancing act

What a remarkable year 2013 has been for investors. As of late November, the global equity markets (as measured by the MSCI World Index) were up more than 30% in Canadian dollars, while the DEX Universe Bond Index was headed toward its first negative year since 1997.

These dramatic returns have given many portfolios an extreme makeover. An account that started the year with a 50-50 split is now likely to be about 57% stocks and 43% bonds. In other words, it’s time to rebalance.

Systematic rebalancing is an important part of portfolio management. Assuming your clients have a long-term strategic asset mix, it’s occasionally necessary to sell assets that have gone up and use the proceeds to prop up those that have declined. But as simple as rebalancing sounds, many investors misunderstand why we do it—and almost everyone finds it emotionally difficult.

It probably won’t boost returns. Because rebalancing involves “selling high and buying low,” investors often see it as an opportunity to boost their returns. It might have that effect, but overall rebalancing is likely to be a drag on long-term performance. That’s especially true during a long bull market like we’ve been enjoying since 2009; selling stocks to buy more bonds every year would not usually have led to higher returns.

Rebalancing, then, is primarily a risk-management tool. If a client’s long-term strategy calls for a 50-50 asset mix, then her portfolio is probably too risky now. Getting the equity allocation back to its target is like adding cold water to a scalding bath.

It works best when differences are extreme. During periods when the returns on stocks and bonds are both in the single digits, rebalancing has a rather muted effect. It’s far more important (and effective) when the differences between asset class performance is large. And this year you can drive a truck through the gap between equities and bonds. We haven’t seen this kind of divergence since the financial crisis of 2008–2009.

Anyone who rebalanced during those terrible six months—when stocks fell more than 40% and government bonds surged—was handsomely rewarded during the recovery that followed. We’re on pace for a 2013 that is almost as extreme: dizzyingly high stocks returns contrasted with losses in bonds. These kinds of rebalancing opportunities don’t come along very often.

It never feels like the right thing to do. Rebalancing makes perfect sense on an intellectual level, but investing is fraught with emotion. Pity the advisor who suggests buying bonds these days, with the fortune tellers continuing to insist rising interest rates are a certainty. The discussion will be even more difficult if rebalancing includes selling stocks in a non-registered account and realizing significant capital gains.

So how should you frame the decision with clients? If the risk management argument doesn’t resonate, maybe they will embrace the idea of “taking profits.” If retirees need to liquidate some assets for income, you may be able to rebalance at the same time, perhaps even by trimming equity positions without buying more fixed income.

There’s no simple answer. As Tom Bradley of Steadyhand once wrote, “Whatever rebalancing you do, be assured that it will feel lousy.” But it’s still the right thing to do.