Portfolio rebalancing is a powerful risk-control strategy that should occupy a prominent role in the management of every investor’s portfolio. Large institutional investors such as university endowments religiously rebalance their portfolios to bring allocations back in line with their original design. Unfortunately, individuals and advisors often allow emotions to override this time-tested and sensible investment policy, often with unpleasant results.
A broad consensus exists among investment theorists that a portfolio’s asset allocation — the mix of stocks, bonds and cash – is the main determinant of both the risk (volatility) and returns the investor will experience. Over time, different assets produce different returns; therefore, the allocation can drift substantially from its original target. It is especially true during periods of very strong or very poor performance in a particular asset class. The result can be a portfolio that has changed substantially from the original and is now inconsistent with an investor’s goals and expectations. Rebalancing allows an individual to periodically realign the portfolio with those goals and expectations.
Despite compelling research and empirical evidence supporting the practice, most investors fail to rebalance their portfolio. Why? Rebalancing runs counter to our emotions, requiring exceptional fortitude to sell assets that have generated the highest returns and use the proceeds to buy assets that have caused the most disappointment.
Faced with this opportunity, most investors instead fall prey to their behavioral biases of fear or euphoria, do nothing, and let the markets dictate their investment strategy. Even worse, others fall victim to the lure of the markets’ momentum and herd mentality, dumping the poor performers in order to pile more money into the winners. When markets suffer steep declines, as they did during the 2008-2009 financial crisis, these investors lose confidence in their plan, sell hard-hit investments at fire-sale prices and seek out the safety of cash and bonds.