Rebalancing or Reframing?

© Can Stock Photo / Juliedeshaies

“Rebalancing” is said by some to be a wonderful portfolio practice, as it restores a predetermined ratio of stocks to bonds. But this consensus wisdom has a cost that is seldom mentioned.

Over very long periods, some kinds of assets have outperformed others. So on the whole, rebalancing over extended periods has tended to remove funds from potential higher-return sectors and placed them in lower-return sectors.

The aim of rebalancing is to reduce volatility. It is generally successful at that. But bottom line, rebalancing may deliver lower volatility to long-term investors at the cost of lower returns.

The only problem with volatility is that people may react to it and behave less than optimally—selling out at a low point, for example. But rebalancing is not the only way to deal with this issue.

Behavior can be changed by reframing. Long-term investors can be persuaded to consider the original starting point (the contributed capital) as the anchor for comparison to current values. Gains in the faster growing side of the portfolio can then be viewed as “house money,” so to speak. After some gains are amassed, then volatility does not need to be viewed as a loss of capital. Selling out at low points may be less likely.

Problems arise when investors define a “loss” as the peak value ever attained less whatever lower value may occur later. By that logic, people could claim that they have lost money most of the time, even while they’ve grown a fortune. It makes no sense to us. Most of the time, markets and stocks are trading lower than some prior peak—they never set a new high every day.

By reframing gains and losses to the cumulative result since inception—instead of over some shorter period—one might substitute reframing for rebalancing and could end up with more wealth. No guarantees, of course.

Clients, this is one of the reasons we talk about long time horizons, patience, and living with volatility. If you would like to talk about these things or any others, please email us or call.

The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual.

All investing involves risk including loss of principal. No strategy assures success or protects against loss.

Rebalancing a portfolio may cause investors to incur tax liabilities and/or transaction costs and does not assure a profit or protect against a loss.