News & Views

Rebalancing – do I really have to?

As humans, it’s fair to say we have a hard time being investors. 

Normally, we like to purchase things when they are lower cost and avoid them when they are expensive, but that is often not the case when it comes to shares.  We tend to be enthusiastic when shares rise in value dramatically, yet when shares fall in value materially, we feel hurt and cautious and we cling to our stable, lower-risk bonds. 

Sometimes, investors will even resort to selling their shares to avoid further falls in the portfolio value however, that’s rarely a good idea, especially if they do not need the bulk of their capital in the foreseeable future.

As a client of Wells Gibson, you will know that we have always sought to rebalance your portfolio on a regular basis, in other words, returning it to the original target asset allocation that we initially established with you. 

Most often, over the past few years, rebalancing has meant selling higher-risk, growth assets (shares) and buying lower-risk, defensive assets (bonds) in a contrarian manner.  This has helped to avoid the portfolio becoming dominated, over time, by the higher-risk, growth assets component of your portfolio and to ensure your portfolio remains consistent with how much investment risk you are willing, able and need to take.

Logically, the reverse also applies; at times like now, the proportion of shares in your portfolio will have fallen below their long-term target.  This is important because the risk profile of your portfolio is now lower and it will be harder for the higher-risk, growth assets remaining to recoup the falls in value when markets eventually recover. 

We can consider this with the help of a simple example.  Imagine you own a £10,000 portfolio split 50% (£5,000) into lower-risk, defensive assets and 50% into higher-risk, growth assets.  In the growth assets portion, you own 50 units of a global shares fund priced at £100 per unit however these units fall 40% in value.  Let’s assume your defensive assets are unchanged in value.  You still own 50 global share fund units, but they are now priced at £60.  Your defensive-growth split has moved from 50/50 to 62.5% lower-risk / 37.5% higher-risk.  It’s time to rebalance.

Figure 1: Market falls leave you underweight in higher-risk, growth assets


Source: Albion Strategic Consulting

Rebalancing i.e. buying shares to realign your portfolio with its allocation target, helps to ensure a quicker recovery, back to where you started.  This is because the breakeven price of your share holdings is now lower. 

Now let’s assume that you rebalance by taking £1,000 from your lower-risk, defensive assets and buying higher-risk, growth assets to get you back to a 50/50 split (see left-hand grid below).  You therefore buy 16.7 units at £60 with the £1,000 raised and now own 66.7 units in the global shares fund. 

In order for your portfolio to reach its starting value of £10,000, your 66.7 units in the global shares fund need to rise 50%, from £60 to £90 per unit (see middle grid below). 

However, if you decided not to rebalance your portfolio, it would only rise to £9,500 with this 50% rise (see right hand grid below).  Furthermore, in order for your portfolio to reach its starting value of £10,000, your 50 units in the global shares fund would need to rise by 67%, from £60 to £100. 

Figure 2: Rebalancing helps your portfolio to recover faster 


Source: Albion Strategic Consulting

If markets fall after rebalancing, the opportunity exists to rebalance again, likewise further reducing the rate of return required to get back to where you were, compared to un-rebalanced portfolios.  This takes courage and discipline, especially when our emotions are telling us to do the opposite. 

Remember, if you are enjoying an income from your portfolio, withdrawing from the lower-risk, defensive assets can get you closer to your target.  Likewise, if you have incoming cashflows, this too can be used to buy growth assets.

As David Swensen, CIO of Yale University’s Endowment and one of the world’s most highly respected institutional investors states[1]:

‘The fundamental purpose of rebalancing lies in controlling risk, not enhancing returns.  Rebalancing trades keep portfolios at long-term policy targets by reversing deviations resulting from asset class performance differentials.  Disciplined rebalancing activity requires a strong stomach and serious staying power.’

Do you really need to rebalance?  The answer for most investors is likely to be ‘yes’ when the time comes.  If we feel a rebalance is necessary, we will be in touch to discuss this with you.

As ever, please feel free to give us a call if you have any questions.

[1]                Swensen, D., (2000) Pioneering Portfolio Management.  New York: The Free Press

For more information please get in touch with the Wells Gibson team.