Strategic Rebalancing in Bear Territory

In times like these, it’s natural to feel anxiety or fear. As our CEO Mark Johnsen recently wrote here, our “fight-or-flight” response can push us to do something – anything – to help relieve those feelings. Typically, our first instinct is to “sell everything” and hunker down until things feel better. That instinct may feel better in the short term but, unfortunately, it may not help us reach our financial goals. In fact, it may prove detrimental. To borrow from an old proverb: A drowning person will grab even for the point of a sword.

We don’t want you to feel like you are drowning or reaching for a sword. Instead, we recommend viewing market uncertainty as something that can be used to your advantage through disciplined rebalancing back to your long-term allocation. We understand that, during extremely uncertain markets like this one, it can feel hard (or even crazy) to buy more stocks. But we believe that sticking to our strategic allocation is a key to long-term success. This means that, we’re likely to recommend most clients buy more equity at current (lower) prices.

To help illustrate how this process might work, we ran a little experiment using data from the 2007-2009 financial crisis. We examined how a hypothetical $1M portfolio of 60% equity and 40% bonds would have fared from the pre-bear peak through the end of 2009.

We used a global stock index (MSCI AWCI) and a bond index (Bloomberg Barclays US G/C 1-5) to simulate investment returns. We chose these indices because we benchmark portfolio returns against them in our client reporting. We assumed that, at the end of each month, if the portfolio equity drifted more than 5% up or down (i.e. reached 65% on the upside or 55% on the downside), we would rebalance back to 60/40. We then compared these results to a 60/40 portfolio without any rebalancing over the period.

Before we share the details, we’d like to stress some important points. First, this is a hypothetical thought experiment. It doesn’t represent the actual experience of any particular client, or of our clients generally. Changes in investments or overall allocation may lead to different results. Moreover, one cannot invest directly in these indices with no costs. The experiment doesn’t take into consideration investment costs like fees, commissions, etc. Finally, past performance is no guarantee of future results.

During our experiment period, our strategic guidelines led to a rebalance three times during the downturn, in June 2008, October 2008, and February 2009. At the end of each of those months, the portfolio equity dipped below 55% so our hypothetical investor bought more stocks to get the portfolio back to 60/40. Note that each of those rebalance points may have felt very scary. You may recall that, in September of 2008, Lehman Brothers filed for bankruptcy and in October the government began aggressive steps to combat the crisis. February 2009 was close to the market nadir of March 9th.

As we can see in the chart below, hypothetical strategic rebalancing actually led to lower portfolio value at the depths of the market: we can see the “rebalance” orange line drops below the blue line. In dollar terms, the rebalanced portfolio has a value of about $660K, less than the non-rebalanced portfolio value of about $700K.

That’s when things change. Although our hypothetical investor had a lower nominal value, she had been buying more and more equity shares over the previous 16 months. Thus, when the market eventually rebounded, our investor was in a better position to capitalize. This of course would have required some patience and a long-term view. Over the next 90 days, the market went up about 30%.² In fact, the rebound was so intense that our experimental portfolio rebalanced away from stocks in May of 2009.

At the end of the year, we can see the rebalanced portfolio edges out the non-rebalanced one. The end value of the portfolios were about $910K and $890K, respectively. Obviously, rebalancing did not protect our hypothetical investor from avoiding any loss. But rebalancing here did blunt the impact of the bear market, just under 1% per year. That may not feel like a big deal, but an extra 1% return, annualized, can make a big impact over time.

In our experiment, the disciplined investor rebalanced four times. Each rebalance came at a time when few people felt good about the market and the future was unclear. Moreover, the market continued to plunge after the first two rebalances. Finally, the investor sold some equities after a huge runup in 2009, but before the markets returned to their previous highs. By taking advantage of the market volatility and uncertainly, rebalancing added value.

We don’t know what the future will bring. Nor can we confirm that strategic rebalancing will always lead to better investment outcomes. But we believe discipline and a long-term focus give us the best chance over time. Your financial plan, including your strategic allocation, represent a “north star” in difficult times. Reach for that, rather than a sword point.

Please let us know if you would like to discuss how this might apply to your portfolio and circumstances.

¹ Source: Yahoo! Finance.
² Source: Yahoo! Finance.