Rebalancing is not a type of Yoga
It is no secret that the stock market has been on quite a “run” over the last several years, particularly in 2017. While this is obviously a good thing for your portfolio, it does create a situation in which you could find yourself taking more risk than you originally planned. That is why at Stewardship Advisors, each quarter we employ a strategy known as re-balancing, which means you could notice some activity on your account statements this month. In fact, a study from Vanguard shows just how important rebalancing can be to maintain the expectations of the portfolio.
As the title states, rebalancing is not a type of yoga. Simply put, rebalancing a portfolio means maintaining your original asset allocation strategy through time. For example, if the long-term goal of a portfolio is to have 60% stocks and 40% bonds and stocks perform well during a given period, the stock portion of the portfolio could grow to 70%, while the bond portion shrinks to 30% of the portfolio. Therefore, using a rebalancing strategy means you would sell stock and buy bonds to realign the weighting to the original goal allocation.
Is it a bad thing if stocks grow to 70% of a portfolio? Isn’t portfolio growth the ultimate goal of an investor? The answer may be yes, but like most things in life, it comes with a tradeoff. With greater stock exposure comes greater risk. One way risk can be measured is by something called standard deviation. A full explanation of how standard deviation is calculated is beyond the scope of this email—just know that the higher the standard deviation the more risk associated with the portfolio.
Vanguard’s study demonstrates that without a rebalancing strategy you could find yourself taking more risk than originally planned. The chart below shows the amount of risk (standard deviation) and returns for three different portfolio scenarios from 1960-2015. Notice that the 60% stock/40% bond portfolio that was not rebalanced has a better rate of return than the 60% stock/40% bond portfolio that was rebalanced. However, while your rate of return increased by 3%, your risk went up by 23%! Without rebalancing the portfolio on an annual basis, that 60% stock portfolio eventually equaled the risk of an 80% stock portfolio! In fact, one could argue that you may have been better off simply starting with an 80% stock and 20% bond portfolio and rebalance it annually instead of not rebalancing a 60% stock and 40% bond portfolio because you may have been rewarded with a better rate of return for taking more risk. This illustrates the point that rebalancing is not about maximizing return, but rather minimizing risk.
| 60% stocks/40% bonds (rebalanced annually) | 60% stocks/40% bonds (not rebalanced) | 80% stocks/20% bonds (rebalanced annually) | |
| Average annualized return | 8.97% | 9.24% | 9.56% |
| Average annual standard deviation (risk) | 11.27 | 13.95 | 13.99 |
As stated above, Stewardship Advisors, LLC utilizes the rebalancing strategy each quarter if the individual positions inside your portfolio get too far outside their intended targets.
As Vanguard’s study proves, rebalancing a portfolio helps to maintain not just the original stock to bond ratio, but the originally intended portfolio risk, which is just as important as the return.
