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The Best Interest » When *Not* To Rebalance?

When *Not* To Rebalance?

In early January 2024, I wrote an answer to reader-of-the-blog Vince’s question about his retirement portfolio. A quick summary of that article is:

If Vince’s portfolio is $4.2M and his annual spending needs are $100,000, he’ll be entering retirement following (essentially) a “2.38% Rule.” That’s way more conservative than the classic 4% Rule.

He doesn’t need to expose himself to undue risk. 60% stocks, 55% stocks, 50% stocks…Vince will be successful in any of these portfolios. Since he has “won the game” of career financial success, he can “stop playing the game” by taking some of his chips off the table a.k.a. reducing his exposure to risk assets (stocks).

Vince wrote back! He asked this week:

If the market goes down, should I perform my annual rebalance into stocks, or because we have 20 years of spending in our fixed income portion of our portfolio, should we only rebalance into bonds from now on when our equities get too high. It may come back to living comfortably vs. passing on more money to heirs. (I choose the former). 

Vince

Ahh! Rebalancing. Let’s dive in.

woman walking on fence

Two Sentences on Rebalancing

Rebalancing is the act of adjusting the asset allocation within an investment portfolio (how much in stocks? how much in bonds? etc.) to maintain the desired level of risk and return.

To learn more, here’s a deep dive on the topic of rebalancing.

Vince’s Question, Summarized

This is such an interesting question!

Vince is asking:

  • Should Vince’s rebalancing go in both directions?
  • If stocks are up compared to bonds, should Vince sell stocks to buy more bonds?
  • If stocks are down compared to bonds, should he sell bonds to buy more stocks?
  • Why does it matter? Because part of Vince’s portfolio approach is that his bond allocation represents 20 years’ worth of spending in his portfolio. He’s not measuring in percentages! He’s measuring in years’ worth of spending.
  • So, in essence, Vince is asking: should he rebalance, even if doing so results in him having “fewer years of bonds” than he’s comfortable with?

We need to understand two different schools of thought regarding portfolio construction. These two schools are definitely similar but with slight, nuanced differences.

two pigeon perched on white track light

The first is the “bottoms-up, bucket method” described on the blog before. It recommends an investor assign a timeline to every dollar in their portfolio, then align those timelines with appropriate levels of risk in investment assets. The money with a 6-month timeline needs to be in cash or ultra low-risk Treasury notes. The money with a 30-year timeline should be in higher risk assets (like stocks) in search of greater returns.

The other common approach is the “expected risk, expected return” method. This approach uses historical data and the investor’s unique risk appetite (a combination of their age, their cashflow needs, their unique mental approach to losing money, etc.) to hone in on the “right” allocation for them. Younger, riskier investors can stomach more stocks, while older, risk-averse investors should own more bonds, etc.

Ideally, the portfolio’s future “expected returns” are then used to test the validity of the overall financial plan (e.g. via Monte Carlo simulation).

person holding laboratory flask

Which Method is “Right?”

Which method is right?

Both methods work. And, in theory, both should lead to very similar outcomes. The two methods differ more in mindset than in “brass tacks.”

I prefer the “bottoms-up, bucket method” because it puts planning first (“give the dollar a job and a timeline”) and then determines appropriate investments. I used that approach in my original response to Vince. He is also using that method in his new question today. Vince feels particularly safe with 20 years’ worth of spending in fixed income. Those dollars have timelines, and he’s built an appropriate cash, CD, and bond ladder for those timelines.

brown metal steep ladder

Is It Right to Rebalance?

Should Vince rebalance? Let’s start by using some reasonable numbers to add color to Vince’s question.

Let’s say Vince needs $100,000 per year from his portfolio. And, based on his personal risk tolerance, he wants 20 years of that annual spending in bonds**. Easy math. That’s $2 million in bonds.

**For what it’s worth, most of the time for most investors, their timelines beyond 10 years should not be in bonds. The math simply says otherwise – that money should be in a higher risk asset, like stocks.

But finance is personal. And many retirees are acutely aware of the fact that “this is all the money I have!” Extra caution – aka extra fixed income – is understandable. It’s helps the investor sleep at night…return on sleeplessness!!! And as long as that extra fixed income doesn’t damage the portfolio’s probability of success, I’m ok with it.

Ok. $2 million in bonds, meaning the rest of Vince’s $4.3M portfolio (as of this writing) is in stocks. That’s $2.3M in stocks. That’s a 55% stock, 45% bond allocation.

close up photo of person breaking a cookie in half
Looks like a 55/45 split, no?

Next, we need hypothetical returns.

Let’s say over the rest of 2024, bonds provide their expected 5% interest while stocks drop 8%. But Vince withdraws $100,000 (from bonds, because that’s why they’re there) to support his annual expenditures. Vince’s portfolio will shift to $2.1M in stocks, $2.0M in bonds.

That’s a 51% stock, 49% bond portfolio. Should Vince rebalance to 55% / 45%?! Let’s go back to first principles. Why did Vince end up 55/45 in the first place?

Because he wanted 20 years of bonds to cover his next 20 years of expenses, and everything thereafter went to stocks. And because his financial plan appears to be perfectly successful with that portfolio.

We should look through that exact same lens when considering rebalancing.

round mirror
  • Does Vince still need 20 years of bonds to sleep at night? Or, with one more year in the rearview mirror, is he comfortable with 19 years of bonds? This is a mental/personal question.
  • Depending on that answer, does Vince need more/fewer bonds than he has right now?
  • And finally, does his financial plan’s probability of success change depending on his rebalancing? This is a math/brass tacks question.

Based on Vince’s investing rationale, his rebalancing decision is a function of bond prices.“I said I needed ~20 years of bonds to sleep at night; do I have them?”

The stock portion of his portfolio has little to do with that! If stocks go up 30%, but he still has 20 years of bonds, I don’t think he should rebalance into even more bonds.

Off the Balance Beam

As asset prices move, our portfolio allocations shift like desert sand beneath our feet. Our targeted risk and return can veer off course and our financial plan’s likelihood of success can decay. These are reasons to rebalance.

However, rebalancing isn’t always needed, depending on your portfolio and the unique rationale of your financial plan. As in Vince’s case, some market movements create more rebalancing needs than others.

person balancing on balance beam

Thank you for reading! If you enjoyed this article, join 8000+ subscribers who read my 2-minute weekly email, where I send you links to the smartest financial content I find online every week.

-Jesse

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