Rebalance your portfolio or not? That's the question

  @Money October 9, 2013: 5:29 PM ET
portfolio

With stocks surging and bonds poised for losses, it may make sense to leave your portfolio alone.

(Money Magazine)

Rebalancing your portfolio has long been investing orthodoxy, yet it has never been easy.

Shifting money from winning funds into laggards is counterintuitive, even though doing so can help reduce risk. But rebalancing has rarely been more challenging than it is today.

The Standard & Poor's 500-stock index is up 16% this year, and the 10-year Treasury bond has dipped 5.2%, which means you should move money from stocks into bonds.

Uh-oh. This is a dicey time to be plowing cash into fixed income. The Federal Reserve has repeatedly signaled that it will dial back its policy of buying bonds to keep interest rates low -- something that will pummel bond prices.

"I'm usually skeptical when someone says, 'This time it's different,' but once in a great while it is," says investment consultant Charles Ellis, author of Winning the Loser's Game. "You really need to think twice about owning bonds today."

So how do you rebalance when what you're supposed to buy looks so risky? One approach: Skip it. Jack Bogle thinks you can. The Vanguard founder has long maintained that the value of rebalancing is overhyped.

"If you can ignore market fluctuations along the way, it's better not to rebalance, since you're likely to get higher returns," he says. If that seems hard to swallow, look at the math and consider the logic behind it. Then see if you're a candidate to follow Bogle's advice -- or whether you'd be better off switching your eggs around.

The case for doing nothing

You know the argument: Regularly getting your portfolio back to your ideal stock-bond mix forces you to sell high and buy low. But over very long stretches, the strategy is unlikely to boost your returns. In a recent study, Bogle compared the performance of a 70% stock/30% bond portfolio that was rebalanced annually with one that was never touched.

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Over the 187 25-year periods ending between 1826 and 2012, the rebalanced portfolio earned a sliver less on average. In 55% of the periods, rebalancing beat doing nothing, by an annualized 0.23%, adjusted for inflation. When rebalancing hurt returns, the penalty was larger -- 0.43%.

Bogle is not alone in pointing out the limits of rebalancing. A 1988 study co-authored by Nobel Prize-winning economist William Sharpe found that rebalancing has worked best when assets that had been performing strongly or poorly made sharp moves back to their historical averages, such as right before the tech crash.

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But when stocks consistently do well, a buy-and-hold strategy delivers superior returns. "Market sentiment tends to persist, so if you're buying low, you may not see a rebound for decades," says Christopher Jones, chief investment officer at Financial Engines, an advisory firm founded by Sharpe.

And by shifting into bonds now, you're almost certainly buying well before the low is even set. With nervous investors already ditching bonds, long-term issues have been hit hard. Vanguard Long-Term Treasury (VUSTX) has fallen 9.9% this year; the 10-year Treasury yield was recently at .65%, vs. 1.8% in January. But that's far below the 10-year's historical average of 4%. And when the Fed pulls back on bond buying, prices will dive even more.

How to hack hanging tough

Sticking with your current mix calls for a long time horizon and a strong stomach. You have to train yourself to resist the urge to trade (think back to how you felt in 2008).

"If you want to sell, ask yourself who's the idiot who wants to take the other side of your trade and why," says Meir Statman, behavioral finance professor at Santa Clara University. It could be a value shopper like Warren Buffett. Statman, who does not rebalance his portfolio, adds, "When the market dips, I remind myself that being down a few thousand dollars doesn't mean I'm a stupid person, and when the market is up, it doesn't mean I'm smart."

When the conventional wisdom wins out

This strategy doesn't just hinge on your temperament. You need time too. "When markets decline, it can be violent," says investment adviser Bill Bernstein, author of Deep Risk. "Short-term losses can be 30% to 40%." Anyone who is near retirement or already retired can't simply wait out severe swings. For you, rebalancing remains an effective way to protect your portfolio.

A portfolio that's rebalanced annually tends to suffer milder one-year losses -- crucial when your investing time horizon is short and a crash hits.

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"Investors who rebalanced through the last couple of bubbles are a lot better off than those who didn't," says emeritus Princeton economics professor Burton Malkiel, author of A Random Walk Down Wall Street. (Both he and Ellis are on the board of the retirement advisory service Rebalance IRA.)

What's more, notes Charles Rotblut, vice president for the American Association of Individual Investors, "losing less in a downturn means you're less likely to panic and sell."

If you must lighten up on stocks, be defensive

When you shift your stock profits into bonds, position your portfolio for the inevitable rate hikes ahead.

A typical core intermediate-term bond fund holds more than 60% of its assets in Treasuries and other government issues, which tend to be the most sensitive to interest rate moves. Instead, favor corporate bonds, which are more closely tied to company earnings than rates. One good choice is Vanguard Intermediate-Term Investment Grade (VFICX).

Another low-risk option is to move into shorter-term bond funds, says Bernstein. A bond fund with a duration of six years -- typical for intermediate funds -- would fall 6% if interest rates climb one percentage point. By contrast, Vanguard Short-Term Bond (VBISX), a MONEY 70 fund, has a duration of 2.7 years; with short-term rates up only slightly, the fund is down just 0.12% so far this year.

If you are investing mainly in a 401(k), however, you may lack bond options beyond a core intermediate fund. Still, about 75% of large plans offer a stable value fund, which performs similarly to a short-term bond fund. You can also invest in more diverse bond funds through an IRA.

And as long as you don't mind taking a little more risk, consider rebalancing into a dividend-paying stock fund instead of bonds. "Given where rates are, which do you think will be worth more in 10 years -- a high-quality company's stock or its bond?" asks Malkiel.

Settle on a middle ground

Rebalancing doesn't have to be all or nothing. At Financial Engines, advisers don't move portfolios back to target allocations frequently. Instead, they adjust based on an analysis of long-term shifts in market conditions. "There's evidence that rebalancing infrequently rather than often has better results," says Jones.

As an individual investor, you're in no position to do complex market studies, so what's your right frequency? "Every year may be too often, since good performance tends to persist," says Bernstein. "Every two or three years is probably right."

And given how hard it is to sit still through market swings, a modest rebalancing plan even gets Bogle's approval. "For behavioral reasons," he says, "most investors are happier if they rebalance, and that's worth something too." To top of page

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Two sides to rebalancing
If you have a long time to invest, rebalancing makes little difference in what you earn. Yet over the short term, failing to rebalance regularly can be costly.
70% STOCK/30% BOND PORTFOLIO ANNUAL RETURN OVER 25-YEAR PERIODS WORST ONE-YEAR LOSS, 1988 TO 2012
Rebalanced 6.1% -27%
Not rebalanced 6.2% -33%
NOTES: 25-year periods ending between 1826 and 2012; average annual real returns.
SOURCES: Jack Bogle; Charles Rotblut, AAII
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