Rethinking Rebalancing by Jonathan Clements
I fear rebalancing has been oversold—and that I was one of the overeager salespeople.
Rebalancing is primarily a risk-control strategy. As financial markets rise and fall, we may find we have more than our target portfolio percentage in large-cap growth shares, or emerging markets, or stocks generally. Rebalancing back to our portfolio targets trims our exposure, reducing the risk of a big financial hit if there’s a reversal in the market’s recent rise.
But rebalancing is also pitched as a way to boost returns. The notion: We should have portfolio targets for value and growth stocks, and large-cap and small-cap shares, and U.S. stocks, developed foreign markets and emerging markets. If, say, value stocks sprint ahead of growth stocks, we should rebalance back to our portfolio targets, potentially selling high and buying low.
Two decades ago, this struck me as a smart and easy way to boost returns. I was wrong. The problem: Market trends often persist for far longer than imagined. If you rebalance among market sectors every year or two, there’s a good chance this attempt to boost performance will achieve just the opposite, capping returns by choking off our exposure to a major market trend that still has many years to run.
We don’t have to look far to find examples of trends that lasted far longer than most investors expected. Emerging-market stocks had a long stretch of sparkling gains in this century’s first decade. That was followed by 15 years of stellar results from large-cap U.S. growth stocks. Rebalancing back to a portfolio’s target sector weightings would have limited these gains—what some would call cutting the flowers and watering the weeds.
To be sure, it would be great to shift from large-cap to small-cap stocks just as the market’s winds were shifting. But I’m not smart enough to succeed at that sort of market-timing, and I’m not sure anybody is.
What to do? My advice: Don’t rebalance among stock-market sectors and among bond-market sectors. The good news is, those of us who favor total-market index funds already avoid this sort of rebalancing. We never fiddle with, say, our mix of growth and value shares, instead letting our portfolio’s allocation change along with the market.
That doesn’t mean we should throw out the notion of rebalancing. I think it’s important occasionally to rebalance between stocks and more conservative investments, thereby keeping a portfolio’s risk level under control. Without that sort of rebalancing, an investment mix would likely become increasingly risky, as stocks grew to be an ever-larger portion of the portfolio.
For those with a contrarian bent, I’d also put in a plug for over-rebalancing during major stock-market declines. The notion: Overweight stocks when they’re deeply underwater. This is something I did during 2007-09, 2020 and 2022. But make sure this overweighting is temporary. As the stock market recovers, look to move back to your target stock percentage, so you don’t leave yourself vulnerable to a big stock-market decline.
Rebalancing is primarily a risk-control strategy. As financial markets rise and fall, we may find we have more than our target portfolio percentage in large-cap growth shares, or emerging markets, or stocks generally. Rebalancing back to our portfolio targets trims our exposure, reducing the risk of a big financial hit if there’s a reversal in the market’s recent rise.
But rebalancing is also pitched as a way to boost returns. The notion: We should have portfolio targets for value and growth stocks, and large-cap and small-cap shares, and U.S. stocks, developed foreign markets and emerging markets. If, say, value stocks sprint ahead of growth stocks, we should rebalance back to our portfolio targets, potentially selling high and buying low.
Two decades ago, this struck me as a smart and easy way to boost returns. I was wrong. The problem: Market trends often persist for far longer than imagined. If you rebalance among market sectors every year or two, there’s a good chance this attempt to boost performance will achieve just the opposite, capping returns by choking off our exposure to a major market trend that still has many years to run.
We don’t have to look far to find examples of trends that lasted far longer than most investors expected. Emerging-market stocks had a long stretch of sparkling gains in this century’s first decade. That was followed by 15 years of stellar results from large-cap U.S. growth stocks. Rebalancing back to a portfolio’s target sector weightings would have limited these gains—what some would call cutting the flowers and watering the weeds.
To be sure, it would be great to shift from large-cap to small-cap stocks just as the market’s winds were shifting. But I’m not smart enough to succeed at that sort of market-timing, and I’m not sure anybody is.
What to do? My advice: Don’t rebalance among stock-market sectors and among bond-market sectors. The good news is, those of us who favor total-market index funds already avoid this sort of rebalancing. We never fiddle with, say, our mix of growth and value shares, instead letting our portfolio’s allocation change along with the market.
That doesn’t mean we should throw out the notion of rebalancing. I think it’s important occasionally to rebalance between stocks and more conservative investments, thereby keeping a portfolio’s risk level under control. Without that sort of rebalancing, an investment mix would likely become increasingly risky, as stocks grew to be an ever-larger portion of the portfolio.
For those with a contrarian bent, I’d also put in a plug for over-rebalancing during major stock-market declines. The notion: Overweight stocks when they’re deeply underwater. This is something I did during 2007-09, 2020 and 2022. But make sure this overweighting is temporary. As the stock market recovers, look to move back to your target stock percentage, so you don’t leave yourself vulnerable to a big stock-market decline.
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