Akweli Parker: Smart investors know how important asset allocation is to balancing their desire for investment return with their tolerance for risk. But what can investors do when their allocation, that is, their portfolio’s mix of stocks to bonds, veers off course from where they planned? In this podcast, we’re going to talk about how to remedy that situation with the act of rebalancing.

Welcome to Vanguard’s Investment Commentary podcast series. I’m Akweli Parker. In this month’s installment, which we’re recording on April 25, 2019, we’ll be speaking with Jenna McNamee, an analyst on Vanguard’s U.S. Wealth Planning Research Team. Jenna and her colleagues recently released a helpful report in their Financial Planning Perspectives series. The report is titled, Getting back on track: A guide to smart rebalancing, and you can find it on our website.

Jenna, welcome and thanks for being here today.

Jenna McNamee: Thanks, Akweli, happy to be here.

Akweli Parker: All right, so, Jenna, to kick things off, let me ask, how might an advisor explain rebalancing to a new client, someone who’s not very investing-savvy, and get them to understand why this process is important?

Jenna McNameeJenna McNamee: Yes, so when you’re a new investor, everything seems overwhelming. So the concept of rebalancing is probably pretty tough to understand. But as an advisor is going through the process of setting up an investor and constructing their portfolio, they talk about what their asset allocation is going to be—their mix of stocks, bonds. What is the right risk that they’re going to take, and what are their goals that they’re trying to achieve?

So rebalancing is the process of making sure that your portfolio stays in line with that target allocation that you choose from the get-go. So as the market kind of moves up and down over time, that allocation that you had originally set at the beginning of stocks and bonds begins to change. And what happens is, you end up having more risk in your portfolio because you might be overexposed to stocks. As a result, you may be vulnerable to big market movements that could knock you off track from achieving your goals. So rebalancing makes sure that you stay in line with what your goals are without running into that risk of losing all of your hard work and savings.

Akweli Parker: That’s a great explanation. So clearly it sounds like this is something that investors should be doing periodically. If you’re an advisor, what would you tell your clients as far as when and how often this process should be taking place?

Jenna McNamee: So choosing that time of when to do it probably seems almost insurmountable to determine. But, you know, it’s really not that difficult. You can take two different approaches to it. You can do a time trigger. So after a certain period of time, maybe a quarter, a month, a year, you take a look at your portfolio and you see what those allocations are and say, “Oh, it’s time to rebalance because they moved a little bit too far.”

Or you can do a threshold trigger, which means that you keep an eye on your portfolio, and you figure out how far that asset allocation has drifted over time; and if it has exceeded a certain percentage, maybe a 1% change, a 5% change—even maybe up to a 10% if you’re willing to take on a little bit more risk—but once it exceeds that threshold, that’s when you would want to rebalance and move it back to that target that you had set in the beginning.

Akweli Parker: All right, so you and your colleagues’ perspectives piece, Getting back on track, it talks about how rebalancing is really about managing risk more than maximizing return. Why does that make sense rather than just reaching for all the return that’s conceivably available?

Jenna McNamee: This is where the emotions come into play. So a lot of times investors will see their portfolio doing so, so well and not [realize] that the stock exposure has kind of grown exponentially faster than the bond exposure. And they’ll think, “Yeah, yeah, I’m doing so great. I’m doing so great.” And then their advisor will come along and say, “Oh, it’s time to rebalance. We’re going to sell out of those stocks and buy some of those bonds that maybe weren’t giving you the value that you were used to.”

That’s really tough, but it’s really important to realize that the reason you’re doing that is to make sure you’re not taking on too much risk and knocking yourself off course from reaching your goals.

Akweli Parker: All right, so if you’re an advisor, I mean, how do you convince your client that that’s the way to go?

Jenna McNamee: Yes, so that’s a tough trick for an advisor. One of the best ways to do that is to come up with a plan in the beginning and make sure that whatever strategy you choose, you’re doing it systematically. And that’s where that time and that trigger approach come into play. Where you can say, “All right, every quarter we’re going to look at your portfolio. And if it does not align with your targets, we’re going to rebalance.” And that way, you don’t really have to think about it. You don’t have to look at the value of your portfolio and say, “Oh, it’s doing well. I think I’m going to leave it” or “Oh, I think I need even more stocks because I’m not getting the returns that I want.” It’s just systematic. We’re doing it, don’t think about it, don’t get caught up in the roller-coaster ride of the market.

Akweli Parker: And it sounds like that’s where an advisor can really add some value in serving as that emotional circuit breaker, right?

Jenna McNamee: Absolutely, absolutely.

Akweli Parker: All right. Okay, so we’ve been talking kind of at a theoretical level. Let’s bring it down to the practical. And could you maybe take us through a representative rebalancing scenario? What would an advisor say to their client, or what would it look like for them walking their client through this process?

Jenna McNamee: Yes. So we can keep it simple, and we can think of a portfolio with just stocks and bonds in it.

Akweli Parker: Sure.

Jenna McNamee: Once an advisor onboards a client and they decide, okay, I’m going to allocate a certain percentage of my money to stocks and a certain percentage of my money to bonds—let’s just say 60/40, that’s the standard portfolio when we talk about a stock-and-bond portfolio. So over time, the value of the stocks might grow proportionately larger than the value of the bonds in the portfolio. When that happens, that original 60/40 allocation that was set at the beginning might be skewed. It might be 75% stock, 25% bond. Now, we all know stocks are risky, so that’s a 15% difference in what you had originally, so that’s a lot of risk that you’re taking on. That’s when you’re going to sell down some of those stocks and use the proceeds to buy some more bonds to bring yourself back into that target 60/40 allocation that you chose.

Akweli Parker: All right. So there’s a little bit of math involved there, even though that was a simple example. And I know that sometimes we characterize rebalancing as a bit of a chore. It’s not the most exciting part of investing. So just how labor-intensive is it to rebalance if you’re an investor?

Jenna McNamee: So when you’re talking high-level stock-and-bond portfolio, it doesn’t seem too complicated. You’re selling from one asset; you’re buying another asset. It seems pretty straightforward. It does become a little bit more complex when you add some additional asset classes or asset types in your portfolio, because you’re trying to keep everything in balance.

Investors can do it on their own if they feel comfortable with selecting the securities they need to buy, the securities they need to sell, and also, [if] they’re familiar with maybe some of the tax consequences that come along—especially if you’re thinking about stocks and the value has grown. You probably have some capital gains in your taxable account that, if you were to sell them, you might actually incur some tax liability.

Also, this is a great place for a financial advisor to add some value in addition to rebalancing. So a financial advisor would probably be great at creating a tax-efficient portfolio and kind of maximizing the use of tax-advantaged accounts to make sure you’re not incurring too much of that tax liability and then also knowing kind of what the tax rules are for those different types of accounts and making sure that the rebalancing is not triggering too much of that liability.

Akweli Parker: So sounds like there’s a lot of subject-matter knowledge that could be very helpful.

Jenna McNamee: Yes. And there is also an option for an investor who is not using a financial advisor. They do have all-in-one funds or balanced funds that have a mix of stocks and bonds already just in one mutual fund, which the portfolio manager—so the person who’s actually managing that mutual fund—is rebalancing in their day-to-day job. So it’s almost like a product that has rebalancing already built into it, so you don’t really have to worry.

Akweli Parker: Great, great. So you talked to us about the two basic different approaches, the time-based approach versus the threshold approach. I’m curious, how do the two compare as far as portfolio performance? Is there much of a difference between the two?

Jenna McNamee: This is a great question, and it actually brings us to the heart of our research. I’m going to talk a minute about a metric that we used in our paper called a Sharpe ratio. So the Sharpe ratio measures the excess return that you receive in your portfolio for each unit of risk that you also take on in your portfolio. And when you look at these ratios, the higher the ratio, the better, because that means that you’re taking on less risk in your portfolio, but you’re receiving more return for the risk that you’re taking.

So in our research, we tested the time strategy, we did the threshold strategy, and we even did a combination of the two. And what we found was that the risk-adjusted return for all of these rebalancing strategies were very similar or exactly the same. But what’s even more surprising is that when we compared those results to a nonrebalanced portfolio, we found that the rebalanced portfolios had significantly better risk-adjusted returns than the nonrebalanced portfolios almost 100% of the time.1

Akweli Parker: Wow! So just one more really strong argument for rebalancing.

Jenna McNamee: Exactly.

Akweli Parker: Kind of almost doesn’t matter which approach you take, right, just as long as you do it.

Jenna McNamee: That’s right. Just do it.

Akweli Parker: All right, great. So as we always like to point out here at Vanguard, costs matter. They’re important. What kind of costs are involved with rebalancing, and how can we minimize them? What are some things that advisors should know?

Jenna McNamee: Yes. So the first costs that come to mind that probably financial advisors will talk to clients about is the transaction costs that go along with it as well as the tax costs associated with rebalancing. So that would be the tax liabilities that you would potentially experience if you were to sell assets at a gain in your taxable account.

There are some things that investors and advisors can do as they rebalance to help minimize some of these costs. The first thing is to focus on tax-advantaged accounts. So this would be like your 401(k) or your IRA. When you make transactions within those accounts, even if you sell something at a gain, you don’t realize any type of tax liability until you actually withdraw the money. So if you have stocks and bonds in your 401(k) or in your IRA, you can actually rebalance in there without experiencing any tax costs.

Akweli Parker: Wow!

Jenna McNamee: It’s great.

Akweli Parker: Yes, that’s amazing.

Jenna McNamee: Another thing that you can do is rebalance with cash flows. So this would be, say, you got your bonus check from work and you want to invest it, what you could do is invest that check into the underweight asset class in your portfolio to bring up that percentage and equal it out to what your target is.

You can also do it when you’re taking withdrawals from your account as well or even if you retire using your RMD [required minimum distribution], withdrawing it from one of the overweight asset classes in your portfolio to pare down the risk that you may be taking.

Akweli Parker: What other strategies should investors and advisors consider to minimize costs?

Jenna McNamee: You can take advantage of annual gifting and charitable giving from your IRA. So, for example, you’re taking your RMD, but you don’t actually need to use it. You can have that check made payable to a charity. And what happens is, you’ll designate that RMD that you took from your overweight asset class, and you’ll designate it as a qualified charitable distribution on your tax return.

So there’s three benefits to this in addition to the rebalancing benefit. One is that you satisfied your RMD, the second is that you’re not paying income taxes on it, and the third is that the charity that you choose is going to get the full benefit of that withdrawal that you take.

Akweli Parker: Wow! So you’re saving costs and doing good at the same time.

Jenna McNamee: That’s right.

Akweli Parker: Okay, Jenna, we’ve covered a lot of territory in a short amount of time. What key points would you hope that investors and advisors listening right now take away from our conversation?

Jenna McNamee: So there are two main points that I hope listeners walk away with from today. The first is that rebalancing is not meant for return maximization. It’s meant for managing risk within your portfolio. The second is that there are many different ways that you can approach rebalancing, but it doesn’t matter which approach you choose. All that matters is that you choose one and you stick to it. And financial advisors can play a huge role in helping investors execute on their rebalancing strategy. They’re not emotionally tied to your portfolio. They don’t lose sleep at night over your portfolio. But when you call up and say, “Oh, but my portfolio is performing so well, I don’t want to rebalance it,” they say, “This is the strategy you chose. We’re going to do it because in the long run it’s going to keep you on track for reaching your goals.”

Akweli Parker: I want to thank you, Jenna, for that excellent wrap-up, and thanks for sharing your expertise with us on the Vanguard Investment Commentary podcast.

Jenna McNamee: Thanks, Akweli.

Akweli Parker: And for you listening, as always, we appreciate that you joined us today. To access the rebalancing guide that we referenced in our conversation, as well as other Vanguard resources on the markets, the economy, and financial planning topics, be sure to check out our website. And to make sure you don’t miss any of our latest insights, simply follow us on Twitter and LinkedIn. Thanks for listening.

Akweli Parker: There is no guarantee that any particular asset allocation or mix of funds will meet your investment objectives or provide you with a given level of income. Investments in bonds are subject to interest rate, credit, and inflation risk. Diversification does not ensure a profit or protect against a loss. All investing is subject to risk, including the possible loss of the money you invest. Past performance is not a guarantee of future returns.

1Jenna L. McNamee, Thomas Paradise, and Maria A. Bruno, 2019. Getting back on track: A guide to smart rebalancing. Valley Forge, Pa.: The Vanguard Group.


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