Has your portfolio recovered from the Great Recession? You might be back to where you were before the crash of September 2008 -- or even better -- if you did one simple thing: You rebalanced your portfolio.
I often speak to my clients about the advantages of rebalancing their portfolios at least annually. Rebalancing takes advantage of any market inefficiencies that may exist and forces you to buy low and sell high, which is the basic tenet of a good investment policy.
The most difficult aspect of rebalancing is getting over the psychological barrier.When the market is in the cellar, no one wants to buy something that just crashed; when the market is soaring, no one wants to sell off any of their winners.
I usually start the process of rebalancing client portfolios after the New Year. However, in early 2009 -- with the market in what seemed a perpetual free fall -- this took a lot of hand-holding and persuasion. Many clients saw no bottom and were very hesitant to add to their equity positions that were down 50% or more in just 12 months. Referring to the cycle of market emotions, we were in the despondency/depression trough. But it was also the point of "maximum financial opportunity." Two quotes come to mind: "The time to buy is when there's blood in the streets"(Baron Rothschild) and "Be greedy when others are fearful"(Warren Buffett).
Rebalancing in action
Let's take a look at an example of how a simple rebalancing can improve your portfolio's performance. Assume you invested $300,000 in the beginning of June 2008 in a moderate risk portfolio that consisted of 50% stocks and 50% bonds. To simplify the example, all of your equity holdings were invested in the S&P 500 index ETF SPDRTrust
By the beginning of March 2009, your portfolio was down about 25%. Your equity holdings went from $150,000 to around $81,000 (excluding dividends), and the market value of your bonds rose about 8% to $159,000 (excluding interest). So, your portfolio lost $60,000 and your allocation was then 66% bonds and 34% equities.
Overcoming your fears, you rebalance back to a 50% equity portfolio, which means you sell $39,000 of your bond holdings and add the same amount in your S&P 500 holdings. Your portfolio then included $120,000 in bonds and $120,000 in an S&P 500 fund.
Fast-forward to March 2010. The S&P gained more than 60% since the beginning of March 2009, so your S&P holdings were worth around $194,000, your bonds were up about 4% to $125,000, and so your total portfolio is now worth about $319,000. That's a $19,000 profit from rebalancing, versus what would have been a small overall loss if you'd done nothing.
My rebalancing example assumes you acted near the exact bottom of the market crash. However, remember, early March was the point when most individual investors were selling out of equity funds and parking their cash in money market funds paying less than 1%. Although this was the point of maximum financial opportunity, it was also the point of greatest fear -- the time when it was most difficult to buy more stocks. But even if you missed the exact bottom, rebalancing within a few months still would have been better than doing nothing.
Rebalancing in reality
That's the theory. Here are some tips for putting rebalancing into practice:
- Try to rebalance your portfolio around the same time every year. Put it on your calendar as a task to accomplish. This may help you take the emotion out of it.
- Don't try and time the market. As famed economist and writer, Burton Malkiel said, "When you time, you have to be right twice: on the sale and on the purchase."
- Set upper and lower limits for rebalancing. For example: Only rebalance if an asset class is greater or less than 3% from your last rebalance. This will help you save on trading costs and potential capital gains in taxable accounts.
- If you own both tax-advantaged (e.g., 401(k) and IRAs) and taxable accounts, try to do your rebalancing in your tax-deferred accounts. Again, this will help eliminate any capital gains and help you save on taxes.
Successful investing requires discipline, which includes annual rebalancing regardless of market conditions. Let a strategy -- not your emotions -- rule your portfolio.
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Kevin Brosious, MBA, CFP, CPA/PFS, is the president of Wealth Management Inc., in Plymouth Meeting and Allentown, Pa. He is also a member of the Garrett Planning Network of fee-only financial planners. He owns shares of the SPDR S&P 500 and the Vanguard GNMA Fund. The Motley Fool has a disclosure policy.