By: Frank Armstrong

By: Frank Armstrong III, CFP®, AIFA®

A disciplined rebalancing practice can add a lot of value to a long term strategic asset allocation program.

Buy and hold might properly be characterized as buy and forget. Thats no way to treat your investments. A program of opportunistically rebalancing a strategic asset allocation will enhance yields and help to control risk.

To review, we advocate strategic global asset allocation using passive investments (ETFs and index funds) to provide asset class exposure to targeted segments of the worlds security markets. Ideally these asset classes have low correlations to one another to help mitigate some of the equity risk. Additionally we heavily overweight small and value segments in all global markets to capture additional premiums over the global market index.

When we originally modeled our asset allocation plan we found that we could dramatically increase expected returns without increasing risk because the correlations in many markets were so low. More than fifteen years of experience in the real world with real money has validated the strategy.

Our strategy takes global diversification about as far as we think it can go using only registered securities that are liquid, totally transparent, and fully disclosed. Its our best guess at an efficient equity strategy. Of course, we wont know how close we are until we all meet back here in 50 or so years when we will have the advantage of perfect hindsight.

We all know that diversification is the investors best defense against specific company, sector, geographic and currency risk. By assigning target weights to each asset class in our investment policy we exert some control over the total portfolio risk-reward characteristics.

The worst thing that can be said of diversification is that you will never have all your assets in the single worst performing asset class. Thats a good thing. Global diversification would have saved investors a lot of grief during the last decade where just about the worst asset class on the planet was the S&P 500.

Of course, you will always have some of your assets in the worst class, and you can never have all your assets in the best performing asset class. This can be very hard for investors to accept, and causes them to second guess themselves and potentially lead them to self destructive behavior. Ill discuss this more later.

Ideally, sector weightings would remain static. However, we know that once we actually fund the investments, the various sectors will begin to diverge in performance. So, to hold the risk return characteristics of the portfolio constant some kind of periodic rebalancing is required. Otherwise over time the portfolio would grow like weeds. Pretty soon your portfolio would bear no resemblance to the investment policy, risk will certainly grow and more than likely returns will suffer.

Rebalancing turns out to be a very good thing indeed. Instead of simply being a maintenance chore to hold the portfolio mix static, rebalancing opens up the possibility of non-trivial incremental gain for the portfolio.

Markets have a longstanding well demonstrated strong tendency to revert to the mean. They often times move in different directions. They fall prey to both irrational exuberance and morbid pessimism and can overshoot both ways. Eventually they reverse course and revert to something close to a mean. Capturing the benefits of those movements doesnt require a forecast or any kind of market timing decision.

Rebalancing mitigates the fluctuations and captures additional return. It enforces a policy of sell high, buy low by systematically paring investment gains and redistributing the proceeds to underperforming classes. When those positions reverse, we capture incremental gains. The more diversity there is between the segments the higher the volatility and the higher the gains. Conversely, during periods of low diversity and/or little volatility there may be few opportunities to capture.

But, a rebalancing policy can be frustrating and counterintuitive to an undisciplined investor. We know from watching cash flows in investment markets that far too many investors chase recent investment returns, buy high, sell low, repeat the process until broke, and then wonder why they cant make money in the capital markets. While they know better, they are almost hard wired to fail as investors. Somehow this self destructive behavior is psychologically rewarding while financially disastrous.

On the other hand, a rebalancing discipline reinforces good behavior and should lead to far better outcomes. Its not satisfying, but it is profitable. Perhaps the best example of how this might help comes from the run up of the S&P 500 and Tech Funds just prior to 2000. Our investment policy called for a 10% of equity allocation to the S&P 500 and no specific NASDAQ or Tech Sectors. While a mindset developed that those sectors could only go up forever, we systematically sold the S&P 500 to keep it in the specified allocation.

We came under tremendous pressure, and lost some clients because we would not increase the allocation to those sectors. In March of 2000 one client famously remarked as he pulled a $3 million account that I was too old and too stupid to understand the new metrics and new economy. Until that time global diversification and a policy of selling winners to buy underperformers looked pretty weak. Needless to say, our investors were not bragging about their returns at cocktail parties in 1999.

The rest as they say is history. The risk of concentrated positions and failure to properly diversify became painfully apparent. During the 2000 2002 time period, our equity portfolio lost less than one third of what the S&P 500 did and subsequently snapped back faster and further. So, if during the 1997 2000 period we looked like losers, over the entire period from 1995 2010 we look like heroes.

In fairness I should point out that our diversified portfolio didnt insulate investors during the recent market meltdown where there was no place to hide as investors fled to quality. But those clients who had the financial resources and stomach to systematically purchase equities by rebalancing between their fixed income and stock positions have gratifying gains on those rebalanced positions.