With the end of the first quarter less than a month away, I’m departing slightly from the usual blog format to provide an educational refresher on portfolio rebalancing. This strategy is especially important now since many investors appear to have experienced significant gains after the market bottomed out last spring.
Rebalancing can help reduce portfolio risk and maintain the established asset allocation, keeping the portfolio on track to achieve its goals. However, rebalancing can be difficult for many investors because it often means selling outperforming assets to buy underperforming assets.
The key here is remembering the investment goals. To take a step back, goal-based investors have an asset allocation that is designed to achieve whatever their investment goals may be, taking into account potential return, risk, and so on.
As time goes on and markets move, the portfolio holdings can become out of balance relative to the desired asset allocation. This is when rebalancing is needed. At its core, rebalancing helps “stay the course” to achieve the ultimate investment goals.
Too often investors think of rebalancing as selling so-called “winners” to buy perceived “losers.” But that sort of thinking is short-sighted. Depending on the time horizon, any given investment can be considered a “winner” or a “loser.”
That’s why Cornerstone chooses to reframe the concept of rebalancing. We don’t see it as a zero-sum game. To us (and our clients), rebalancing is like pruning in a garden. It keeps the garden tidy and orderly while helping achieve the desired goals.
Image by Arturs Budkevics from Pixabay
With a garden, that may be a picturesque bed of roses or a patch of tasty tomatoes. For investors, it’s often having the means necessary to live the retirement they desire. So, if anything, we think rebalancing is a winning proposition because it takes the positive fruits of investment decisions (gains) and repurposes them to generate what is ultimately desired (the investment goals).
Staying on Target While Remaining Flexible
From a basic standpoint, the process behind rebalancing is simple. When investors create their plan and goals, they settle on target allocations of specific asset classes that are meant to coincide with their risk tolerance. As some of these asset classes outperform while others underperform, the allocations naturally stray from their targets. Rebalancing is merely the act of restoring the portfolio to those goal-based targets.
But to be clear, rebalancing does not always mean completely selling one asset class to buy another. Often, it’s merely trimming gains to reallocate elsewhere, which almost is a manner of dollar cost averaging without having to add new cash. Put another way, we’re using gains to buy assets that are on sale. Again, these are more growth-oriented outlooks than a “selling winners to buy losers” mentality.
We find it’s also helpful to build flexibility into a rebalancing plan. Investors don’t need hard asset allocation percentages in their portfolios. Instead, consider asset allocation ranges, which can lighten the rebalancing needed.
For instance, at Cornerstone we use a target percentage with a +/- 2 percent buffer. This helps keep portfolios on track while minimizing the number of transactions needed, which is especially important in taxable accounts given the implications of short- and long-term capital gains taxes.
Buy on Sale, Reduce Risk, Repeat Regularly
As we’ve touched on, the most difficult part of rebalancing is often the counterintuitive psychological aspect of selling assets that performed well to buy ones that underperformed. But investing is different. There’s an old saying – “Great companies make for great investments at great prices.”
Remember, assets that have appreciated in a portfolio have gone up in value and price. Thus, these assets are in effect more expensive to buy or hold. On the contrary, an asset that has decreased in price is less expensive and can be bought “on sale.”
Also keep in mind how markets work in cycles:
It’s likely the out-of-favor asset may soon be back in favor as investors feel they’re priced at a discount and provide for a good opportunity. Since the election we’ve seen a cyclical rotation and outperformance from unloved sectors like energy and financials. So, while it's tempting psychologically to double up on your winners, we know that isn't always wise. Not only does it go against the fundamental mantra of “buy low, sell high,” it also adds risk.
If you never rebalance your portfolio, your allocation will gradually shift it and you’ll no longer be invested according to your goal-based risk tolerance. Avoiding this requires regular maintenance of your account. That’s why Cornerstone rebalances at least quarterly on a scheduled basis. This is part of an effort to remove emotion from the investment equation, which may be the most important aspect of staying the course.
Is the Stock Market Beginning the Seemingly Long-Awaited Reset?
As readers of this blog is aware, we have been calling for a market peak in Q1 2021. More specifically, based on data from our trusty Big Money Index (BMI) and the overbought nature of the market we expected this to come at the end of January. As we have discussed, it happened, that is until the coordinated “private bailout” that rescued the market resulting from the Robinhood fiasco. Those events stalled the necessary reset of the short-term overbought market we were in.
Last week though, we finally saw the BMI finally dip below our overbought measure of 80% (79.9%) mostly being dragged down by the prior leadership of technology. This has been felt by investors in the recent volatility in the markets.
Big Money volumes have also been exploding contributing to the market price action:
When trying to predict where the market is going, we must know what the Big Money signals themselves are doing. Nonstop big volume buying means that higher prices are likely ahead, while extreme buying usually means a pullback is close. Sustained big selling indicates lower prices are coming, while extreme selling indicates a sharp reversal is near. I need to inform you that stock selling is clearly increasing:
We are also seeing a significant acceleration in ETF selling:
This is not to freak out our readers. We merely need to follow the data in order to be prepared for the ebbs and flows of the market in the short term. Remember, this does not change our bullish thesis for the intermediate term throughout the remainder of the year. This is normal and necessary in the short term.
Rather, it appears that we are seeing a huge rotation in the market, a “sloshing around” of sorts. Last week saw selling in Utilities, Healthcare, and Staples. Tech seemed equally distributed between buying and selling, but in reality, tech-stock prices are too high to breach a technical sell signal yet. By contrast, buying was in six sectors, Financials, Energy, Industrials, Discretionary, Materials and Real Estate.
So, while money is sloshing around the market, rotating out of growth and into stocks that benefit from the re-opening of the economy, selling overall is picking up. What this typically means is that as the BMI falls from overbought (as just happened) the selling has just begun. Predicting the future is impossible, unless you are the Simpsons writers (30 Times the Simpsons Predicted the Future), but we do try to follow the data at Cornerstone and the data is telling us that the current short term top is in and we should expect some chop over the coming weeks. Most importantly though, remember this is healthy for the markets and not unexpected. Following the data allows us to not make unnecessarily emotional investment decisions during market resets like this.
Securities sold through CoreCap Investments, LLC. Advisory services offered by CoreCap Advisors, LLC. Cornerstone Financial Services, CoreCap Investments, and CoreCap Advisors are separate and unafﬁliated entities.