This cobbler’s children wear shoes!

"The cobbler's children have no shoes" refers to the phenomena where people are successful at doing something in their professional lives, but don't practice it in their personal lives. Well, my kids were close to being shoeless, but no more!

I just completed the annual rebalancing of my portfolio. Although I do this on a regular basis for my clients, for some reason it’s too easy to put off doing my own rebalancing—there’s always something more pressing that needs to be done. Sometimes that “something” is nothing more than walking around my neighborhood to check out all the Christmas lights. Or cleaning the toilet.

Anyway, since I don’t want to be a “do as I say, not as I do” planner, I finally got around to doing what I know is critical to my portfolio’s ability to help me reach my long-term goals.

What does “rebalancing” mean?

Rebalancing means resetting your portfolio’s asset allocation back to its original percentages. For example, if your portfolio is made up of two stocks with a 50/50 allocation you’ll own 50% in stock A and 50% in stock B at the beginning of the year. You determine that’s the correct allocation for your situation. During the year stock A does great, but stock B does a lot of nothing. By the end of the year you now own 70% stock A and 30% stock B (70/30), as your portfolio “drifted” based on market returns. To rebalance you sell enough stock A and purchase more stock B with your proceeds to bring you back to your 50/50 target allocation.

Sell high/Buy low

See what you did when you rebalanced? It forced you to sell the stock that’s at a high, and buy more of the stock that has underperformed. Of course, there’s no guarantee that stock A won’t continue to appreciate, or that stock B won’t go down in value. However, if these are stocks from two well-run companies that you definitely want to hold on to for the long-term, this is a wonderful strategy that automatically forces you to do what you know should be done.

Rebalancing minimizes risk

According to Vanguard’s March 2014 whitepaper “Putting a value on your value: Quantifying Vanguard Advisor’s Alpha”, they estimate that up to 0.35% (35 basis points) can be added to a portfolio’s risk-adjusted return when a 60% stock/40% bond portfolio is rebalanced annually, versus the same portfolio that is not rebalanced (and thus drifts). Without going into all the details, what they found is that if you don’t rebalance your portfolio you’ll increase your risk, but not be compensated for that risk through higher returns.  Higher risk without higher returns? No thank you!

How does rebalancing lower risk?

Since stocks outperform bonds over time, an unbalanced portfolio will increase its stock allocation over time through drift. However, along with the higher returns of stocks, comes the increased market volatility of stocks. For example, if it’s determined that a 60/40 portfolio (60% stocks and 40% bonds) is the best fit for your risk profile and the stock market has a few good years, you may find yourself with a 70/30 portfolio, if you don’t rebalance yearly. Sure, your return would be higher than if you didn’t rebalance, but you’re now taking on more risk than you originally wanted. Now suppose that in Year 4 the stock market has another year like 2008? Because of your increased stock exposure you would see a decline in your portfolio’s value that’s greater than your comfort level. After all, if you were comfortable with a 70/30 portfolio, you would have chosen that allocation in the beginning.

Rebalancing is a “leap of faith”

It’s hard to buy more of the “dog” held in your portfolio, with the assumption that it will eventually outperform the rest of your portfolio. It’s doubly hard when you have to sell the part of your portfolio that has recently performed the best in order to pay for this “dog”! However, this is exactly what rebalancing does.

When I recently rebalanced my portfolio and had to buy more emerging market stock, I held my nose and reminded myself that all asset classes have their up years and their down years. When that wasn’t enough I reminded myself that emerging markets were on “sale” and who doesn’t like a good sale!J

Being a financial planner, I’ve seen all the research showing the benefits of regularly rebalancing a portfolio, yet I still don’t find it easy all the time. If I find it difficult, I can only imagine how difficult it is for the layperson.

If you’ve been putting off rebalancing your portfolio I suggest you just do it and get it over with. You’ll be happy that you did...and so will your portfolio.