Why Annual Portfolio Rebalancing Is a Myth

In this undated stock photo an investor checks his financial portfolio online. Rafe Swan/Getty Images
In this undated stock photo an investor checks his financial portfolio online.

If you search online for “portfolio rebalancing,” you’ll get a long stream of articles stressing the importance of regularly adjusting your portfolio’s asset allocation to keep it from getting out of whack.

The logic behind this: Over time, the dollar-value percentage of each type of investment you own changes. So many advisers recommend annually restoring your portfolio to its original plan (its asset allocation) by selling highly appreciated investments and adding to beaten down ones. The idea is to keep your portfolio from being over-weighted in any one type of investment.

Rebalancing can involve adjusting the percentage of your total portfolio that you have in different asset classes, such as stocks and bonds, or the amount you have in different types of stocks.

Generally, there’s nothing inherently wrong with rebalancing, but it’s typically carried out way too far. The financial services industry has spun the dogma that annual rebalancing is an essential practice that no intelligent investor can afford to ignore. This helps these companies sign clients and boost trading commissions. But is frequent rebalancing really in your best interest?

If you’re one of those people who accepts the idea that rebalancing annually is essential, especially if your asset allocation is the least bit out of kilter (most years, it will be), the beginning of 2016 is a good time to examine this conventional thinking to see if it’s likely to work for you over the long run. You may end up adopting a more critical view.

Here are some things to consider:

Why annually? The common practice of annual rebalancing centers on the notion that stocks will go up a lot in one-year cycles. The obsession with one-year cycles doesn’t make sense. Often, stocks don’t rise much in 12 months, and those that do often continue to rise for a few years with bull markets. Bear markets are usually shorter. So by selling prematurely, investors may leave money on the table.

Percentage players. It can make more sense to rebalance by percentage. For example, if your original plan was to have 70 percent in stocks and 30 percent in bonds, believers in this method might make changes to restore this allocation once their portfolios hit 80-20. Percentage rebalancing may well be necessary in response to major market events, like the market turmoil that has occurred so far this year.

Yet many people who make a lot of money in the markets rarely, if ever, rebalance because they don’t want to sell shares that are leading the market. The question is: Should investors be unsettled by gains that are continuing? It’s all a matter of your risk tolerance.

An obsolete formula. Many people who habitually rebalance their portfolios do so to realign them with a shopworn asset allocation that was wrong in the first place. This allocation, calling for too much in bonds to begin with and far more as investors approach retirement, has been around for decades. Various studies have shown that long-term investors do better by having far more money in stocks than this allocation allows. Having your money in different types of investments can reduce risk, but it’s crucial to understand the inherent risks of one of type of investment versus another over the long term.

Sleep at a high cost. The primary argument for rebalancing is that it can help you sleep soundly because it’s viewed as reducing risk. Yet, the cost of the taxes this triggers over decades in accounts that aren’t tax-deferred can be an expensive sleeping pill. If you realized how much that sleep is costing you, you wouldn’t sleep so well.

If winning stocks are held within a tax-deferred account, such as a pension or a 401(k) plan, there isn’t any annual tax drag. Yet rebalancing by selling stocks to invest in bonds—as many investors are advised to do-makes no sense over the long term because of the superior long-term average returns of stocks over bonds. And currently, as interest rates are beginning to rise, bonds just aren’t a good investment.

A favored approach of many professional investors is to rebalance via opportunistic reallocation. When a certain asset class, or sector, has been beaten to a pulp, they buy more shares. Or, when a certain stock/sector is at abnormally high valuation and historically unlikely to remain at that lofty level, they sell some of these shares. After a year like 2015, this would mean selling shares of some of the few star companies that have recently driven the entire market, and add some cyclical ones that are currently underperforming.

If sudden, significant market dislocation has resulted in your portfolio being heavily over-weighted in one area, consider selling some of these holdings and re-investing in other areas because they have clear prospects for growth—not just because they have low current values. These days, such opportunists are buying energy and industrial stocks because they’re beat up, and because the demand for commodities and industrial production is likely to rise in the coming months or years, if history is any guide.

Dave Sheaff Gilreath is a founding principal of Sheaff Brock Investment Advisors LLC. He has more than 30 years of experience in the financial services industry, beginning with Bache Halsey Stuart Shields and later Morgan Stanley Dean Witter. At Sheaff Brock, he shares responsibility for setting investment policy, asset allocation and security selection for the company's managed accounts. He also consults with the clients on portfolio construction. Gilreath received his Certified Financial Planner® (CFP) designation in 1984. He attended Miami University in Oxford, Ohio, where he earned a B.S. degree.

Any opinions expressed in this column are solely those of the author.