Rebalance in May and Go Away

Investors love pithy advice. "Buy low, sell high." "Use the 4% Rule." "The trend is your friend." And of course, that old chestnut, "Sell in May and go away." That last one evolved based on the impression many market watchers gleaned that Wall Street generally performed best between November and April and delivered lackluster results during the summer.

But as co-host Robert Brokamp points out in this Motley Fool Answers podcast, while the historic data shows that pattern is common, the adage's suggested response to it -- hit the sidelines for half the year -- is the wrong way to go. In this "What's Up, Bro?" segment, he offers a better idea: This could be just the right time to rebalance if you need to. But even if your asset allocation has gotten far out of balance compared to your original plan, that's actually a mighty big "if."

To catch full episodes of all The Motley Fool's free podcasts, check out our podcast center. A full transcript follows the video.

This video was recorded on June 4, 2019.

Alison Southwick: So, Bro, what's up?

Robert Brokamp: Well, Alison, a few episodes ago we highlighted how this has been an extraordinarily good year to be an investor in U.S. stocks. From January to April, the S&P 500 returned over 18%. It was the best four-month start to a year since 1987.

And then came May. So as of this taping, May 30th, the S&P 500 is down 5.5% this month. So when stocks do well for the year, but then they start to slide in that fifth month, we often hear one of the most well-worn adages in Wall Street which is...

Southwick: Sell in May and stay away.

Brokamp: There you go! You picked that one up. Excellent! So the basic premise is that the stock market does not do quite as well from May to October and it turns out there's actually some proof of this. Here's some numbers from LPL Financial that looked at six-month returns from 1950 to 2018 -- the first six months, and then the next six months, and so on. On average, over a six-month period, the S&P 500 returns 4.3%. The best period, November to April, the average return is 7%. Worst? May to October is 1.5%. But they also looked at the percentage of times that the market actually makes money over that period. On average, over a six-month period, the market makes money 69% of the time. The best, again, is November to April. It makes money 76.8% of the time. The worst is April to September, but just slightly behind it is May to October. There is some evidence that May to October is not quite so good. But, historically you are still likely to make money even if it's not as much, so of course I'm not going to tell you that you should cash out your stocks and wait around until Halloween to get back in the market.

But, I think it might be worth considering doing a little tweaking to your portfolio. Maybe we should change it to "rebalance" in May and stay away. Why would you do that? Well, if you haven't rebalanced your portfolio, especially over the last decade, it has become much riskier. As an example, let's say a decade ago you were 75% stocks and 25% bonds.

Over this decade it's grown to where you are now 88% stocks, but you've also gotten 10 years closer to retirement if you are not yet retired, or you've just gotten older when generally speaking you should be getting more conservative.

So rebalancing really isn't necessarily about getting better returns. It's about being in control of the risk characteristics of your portfolio. That is the bottom line of a recent report from Vanguard which came out on rebalancing and looked at a few things.

First of all, it looked at the returns of a non-rebalanced portfolio vs. a rebalanced portfolio, and there's no question, especially when you're rebalancing between stocks, bonds, and cash that rebalancing lowers your returns. On average you're going to earn higher returns if you stay all invested and just let stocks overrun your portfolio, but you widen the possible results.

If you never rebalance, you could have extraordinary returns, but there's also a chance that you will have not-so-good returns; whereas, if you rebalance your portfolio on a regular basis, you narrow the range of your returns. You won't have exceptional returns, but you won't have horrible returns.

The next question is how often should you rebalance? Well, Vanguard's report looked at that, too. There are really two ways to do it: either by time -- annually, quarterly, monthly -- or by threshold, meaning once your allocation has gotten out of whack by a certain amount, you bring it back in. For example, let's say you decide you should have 75% in stocks, you would rebalance once it grows to 85% or down to 65%.

What's best? Interestingly, it almost doesn't matter. The returns are almost identical as well as the risk profile, whether you look at volatility or something known as the Sharpe ratio. What's most important is that you're doing some sort of rebalancing once in a while. I think every few years is probably good enough.

I'm going to close with a few tips about how you should do the rebalancing -- the nuts and bolts of it.

First of all, whenever possible do it within an IRA, 401(k), or a tax-advantaged account so you don't have to worry about paying capital gains taxes on that.

You can rebalance with cash flow, so if you are still saving for retirement you can devote your contributions to your 401(k)s and IRAs to the stuff that's underweighted.

If you are retired, you can rebalance by taking money out of the investments that have done particularly well.

If you're charitably inclined, you can rebalance by donating appreciated stock. When you donate appreciated stock to a qualified charity, you avoid paying the capital gains and you might get a tax deduction.

Or, if you're 70 1/2, you can rebalance by making what's known as a qualified charitable distribution from your traditional IRA. You don't have to pay taxes on the distribution that way. Also, it counts as your required minimum distribution.

If one or more of those things sound good to you, make sure you learn more and maybe talk to your tax broker as there are some rules you have to follow.

You can also gradually rebalance your portfolio by not automatically reinvesting the dividends into the stocks that pay them. It could be bonds as well, or any of your mutual funds. Instead, either let the dividends accumulate in cash and then put the cash toward underweight investments, or, if you're within a decade of retirement, it actually makes sense to just let that accumulate in cash and bonds, because as you get closer to retirement that will naturally make your portfolio more conservative.

And finally, consider the quality as well as the quantity of all your investments. Rebalancing is a good opportunity to look at everything you own. Do that thought exercise. Look at an investment and think, "If I didn't own this would I buy it today?"

If you have actively managed mutual funds, we've all heard that most of them are not beating index funds, so this is a good opportunity to maybe get rid of some of your underperforming funds. Is management still doing the job you want them to do?

Using all those things, it's a good time to reevaluate your portfolio for any investments that you no longer believe in. You can rebalance just by getting rid of them.

The bottom line on this is rebalancing is a risk management strategy and not a return-enhancing strategy. If you are very aggressive or if you're more than a decade from your financial goal, it may not be all that important. But if you are conservative, or moderate, or if you're getting within a decade of your financial goal -- buying a house, going to college, going into retirement -- managing your risk is much more important and rebalancing is one way to do that.

And that, Alison, is what's up!