By Steve Tepper, CFP®, MBA
June was another interesting month. I don’t know about you, but I’m kind of longing for boring months for a while. But at least June started out with a positive kind of interesting. During the first week, some of the accounts I manage started to signal they were ready to be rebalanced … because of positive market performance! After the slaughter of March and April, how wonderful it was to look at the accounts that I had made trades on at or near the lowest point of the March panic, and realize they had earned back enough to sell off some equities.
I was looking forward to trading more accounts as the rebound continued, but (as always) the market had its own plans. The second week of June brought more panic selling, including an 1,861-point drop in the Dow in one day (its fourth-biggest point drop ever).
Plans for more rebalancing were out the window for a while. Instead, I pondered if a second wave of panic might necessitate more rebalancing the other way soon.
I don’t know if that’s coming or not. Maybe. And if it does, fine. Rebalancing works. And I’ve got numbers to prove it.
Our standard procedure is to rebalance accounts if they get more than 5% out of balance at the top level (stocks vs. bonds). So if we are targeting your account to have 60% stocks and 40% bonds, we would sell stocks and buy bonds if stocks rose to more than 65% of the account, and we’d do the reverse if stocks fell below 55%.
Simple math tells us how much to buy and sell. Selecting which holdings to buy or sell is a little more complicated, as we have to consider capital gains, trading fees, your cash needs, and other factors. But for the following exercise, I ignored all the details and just looked at the top level of total stocks and total bonds.
I hypothesized a series of negative daily stock returns that would result in a one-third drop in stock prices (about what we had earlier this year), followed by a series of returns that would take the stock value all the way back to its starting value. I assumed there would be no trading at all in the account. Then I repeated those same negative and positive returns to take the account value down and back up again.
On the bond side, I just assumed a very small (.01%) constant daily return.
I started with $500,000 in the account, allocated 60% to stocks and 40% to bonds, or $300,000 and $200,000 respectively.
So basically, the stocks in the portfolio fell to about $200,000, then went back up to $300,000, and then did the same thing. Bonds just added about $20 per day and increased steadily over 36 trading days from $200,000 to $200,721.
(Note: Bonds haven’t been quite that reliable in 2020, but the small amount of volatility they have shown wouldn’t impact the value of rebalancing. And of course, stocks haven’t been as predictable either and I have no indication they will be—it’s just a model!)
So now comes the fun. (Yes, this is how I define fun). Look at the same account, the same daily returns, and every time stocks drop below 55% of the total, do two rebalance trades (at a cost of $10 each): Sell bonds and buy stocks. If stocks rise above 65%, do the opposite. The purpose is to see how much it impacts the ending balance of the account.
Well, the answer was quite a bit. A rebalance trade was triggered each time the market went down, and another each time it rebounded. And rather than ending up with a balance of $500,721 as we did without rebalancing, the ending balance was $313,367 in stocks and $205,922 in bonds for a total of $519,289. That’s about a 3.9% return, compared with a 0.1% return if we had done no rebalancing.
Maybe a 3.9% return doesn’t thrill you, but remember what the stock market has given during that time: 0%. My hypothetical market returns were specifically selected to leave your stocks at the same value as when you started (if you took no action). But because of rebalancing, you have more.
Big market drops are not my idea of fun—I think I share that with most of you. It’s not just portfolio values. It’s that market drops usually happen for a reason, and it’s rarely a good one. Bear markets of more than 30% drops usually mean people are losing their jobs, losing their businesses. 2020 has given that and so much more misery. And it’s only July.
That’s why we aren’t happy to do rebalancing in falling markets, but we must. The chance to keep ourselves well-positioned for when the panic ends is a small silver lining around some very dark, ugly storm clouds.