Many of us have spent more time outdoors than ever before during the pandemic. My two boys, aged three and six, my wife and I have been fortunate to discover many hiking and nature trails in our region. On our adventures, we have noticed that fellow travelers appear to move along the path at a constant speed, pacing themselves to get from point A to point B while still enjoying nature’s beauty. We opt for a different approach: sprinting for a stretch in the correct direction, then in the wrong direction, and then taking an impromptu rest in the middle of the trail. There is always a need to snap sticks and hurl rocks in the water. We bring chaos to a system that otherwise follows the rules of order.
Like my family’s approach on our hiking trips, the adventure of investing unfortunately follows a similar path. Of course, life would be easier on the way to our financial goals if stocks paced themselves to earn their historical average every year. However, we know that they sprint for chunks of time and sometimes in the wrong direction! This characteristic, however unpleasant, can potentially help investors add value to their portfolios via rebalancing. Last year, as shown in Figure 1, was a powerful example.
Stock markets were off to a rocky start in the first quarter of 2021: global stocks were down 21% (as proxied by the iShares MSCI All Country World Index ETF). But the full-year result for the same ETF was +16% after a 47% rally over the period from April to December. A long-term investor—someone more concerned with portfolio values in 10 years than the uncertainty posed by COVID-19—could take the view that stocks were discounted and purchase more, up to their risk target. The key to this decision is having a place in your portfolio to fund such a purchase. The figure below shows how U.S. investment-grade bonds (as proxied by the iShares Barclays Aggregate Bond Index ETF) performed over the same periods. While investors violently sold stocks, bonds gained 3% in the first quarter, providing a place in the portfolio to generate cash for buying stocks, before adding 4% more to close the year up 7%.
The rebalancing opportunity provided by this dispersion in short-term returns is illustrated below at four risk levels. An aggressive investor, who starts the year with 90% of their portfolio in stocks (ACWI) and 10% in bonds (AGG), would have arrived at the end of the quarter with a portfolio under target for stocks (87% instead of 90%). If they sold bonds to repurchase stocks, their full-year return would have been 16.4%. This return represents a 0.9% increase on what they would have earned had they done nothing. The rebalancing difference for growth, balanced, and conservative risk levels would have been 1.9%, 2.6%, and 2.4%, respectively. These figures are higher because stocks fell under target by a larger amount (5% to 7%), allowing for more sell high, buy low action.
| Aggressive:
90% ACWI / 10% AGG |
Growth:
75% ACWI / 25% AGG |
Balanced:
55% ACWI / 45% AGG |
Conservative:
35% ACWI / 65% AGG |
|
| No Rebalancing | 15.4% | 14.1% | 12.3% | 10.6% |
| Rebalancing at the end of Q1 | 16.4% | 16.1% | 14.9% | 12.9% |
|
Difference
|
0.9%
|
1.9%
|
2.6% |
2.4%
|
Proactively setting your portfolio up to take advantage of market chaos requires careful planning on two fronts: risk management and diversification. We take care to confidently set portfolio risk targets so rebalancing can be disciplined even when prevailing market conditions make it uncomfortable. If you have a risk target and are willing to take a long-term view, it should be easier to buy stocks back to a level you were comfortable with before they sold-off (and you’ll probably get them cheaper). The other important element in this equation is thinking hard about your portfolio’s non-stock holdings. Rebalancing does not work as well if you must sell assets that have depreciated and does not work at all if you can’t sell due to illiquidity. 2021 is showing that it should be more than just bonds in this bucket as rising rates (which hurt bond returns) can be a catalyst for stock weakness. Furthermore, bonds are a diverse asset class – behavior in sell-offs will differ materially from Treasuries to high yield corporate bonds.
How can you diversify and monitor your portfolio to take advantage of the market’s chaos with rebalancing and stay on risk target? Reach out to a Keel Point advisor to talk about making this strategy a central part of your financial plan. While the journey may be more chaotic than you prefer, we hope thinking in terms of rebalancing helps turn that negative into an opportunity.