Today, we are going to look at the benefits of portfolio rebalancing. A client recently asked: "With the recent poor performance of bonds relative to equities (shares), what is the point of selling things that are doing well (equities) to buy things that are doing less well (bonds)?" Before we start (and as we emphasise to all our clients), please continue to ask questions - we are here to provide peace of mind, and if you are concerned about something, there is no doubt that others are too.
Rebalancing is a tool to manage risk, not maximise returns.
To demonstrate this, we will build two portfolios. Both will be based on the No-Brainer Portfolio (NBP) and contain 60% equities and 40% bonds.
Portfolio 1 will be rebalanced quarterly. Rebalancing means selling the assets that have been performing well and buying those that have been doing less well to ensure we remain close to our desired asset allocation (60% equities and 40% bonds).
Portfolio 2 will not rebalance. Given that equities tend to outperform bonds over the longer term, we would expect to see:
The content of the portfolio moving more towards equities as time goes by.
The non-rebalanced portfolio, therefore, outperforming the rebalanced portfolio.
If we look at the data, we can see that this has been the case over the last 20 years.
But as we pointed out, rebalancing is about managing risk. Let's look at the relative volatility of the portfolios (how much each portfolio moves up and down). The non-rebalanced portfolio is more volatile (9.12 vs 8.24 - annualised standardised deviation) than the rebalanced.
A short-term focus can be detrimental to your wealth.
Bonds have indeed performed poorly over the last few years. Rising interest rates around the globe have seen their prices fall over a prolonged period.
While this is never enjoyable to live through, it's important to note that the recent performance is well within expectations. Bonds, like equities, are risky assets, and periodic periods of low returns should be expected. Abraham Okusanya summarised it well.
"Another takeaway from the past year is that your point of reference matters. If your investment thesis is based entirely on the last 20 or even 40 years, you probably got a nasty surprise. If you base your thesis on 100+ years, however, the returns of 2022 fit into the range of outcomes within that dataset"
Indeed, I covered this scenario in my book, Planning for Retirement: Your Guide to Financial Freedom, coincidentally published around three years ago, before most of the recent events.
Scenario 1 – Jump in global interest rates
The global economy is booming, and inflation is starting to spike. To counter this, central banks around the globe raise interest rates. Bond investments become less appealing as their fixed payments (coupons) become less attractive than, for example, the increased rates on offer from bank deposits. Despite having a low duration, Bond A’s price still drops from 99 to 96. However, Bond C, with a much longer duration, suffers far more, its price falling from 98 to 70.
However, what happened over the last few years was just one potential outcome. Looking back at the global financial crisis, we see how things have panned out very differently in the past. Over two years, starting in 2008, bonds performed well as central banks cut rates and investors fled to safety (selling equities).
Imagine if you had entered this period having turned off rebalancing because equities had performed so well vs bonds from 2003-2008.
If we look at the performance of equities and bonds from 2008-2010, we can see how well bonds performed relative to equities. In recent years, the opposite has been true. Unfortunately, it’s pretty much impossible to pick winners in advance, whether individual equities or asset classes. The good news is that we don't need to try and pick winners - we can achieve good outcomes with a regularly rebalanced, diversified portfolio.
Market timing is difficult!
As I wrote this, I noticed a headline in the FT - U.S. bonds on track for the best month in nearly 40 years.
There are several key takeaways:
1. Rebalancing is important.
It controls our portfolio volatility and allows us to sell assets that have been doing well and buy those that have been doing less well (buy low, sell high!).
At least one component of your portfolio will likely be underperforming at any given time. If this is something that you find challenging, there are two options to consider:
If managing your retirement on a DIY basis, consider holding a single fund, multi-asset portfolio that doesn’t enable you to check the underlying assets' performance.
Check your balances infrequently. Our retirement planning process allows clients to be confident in spending their retirement money even during difficult times. We have stress tested for far worse than we have experienced over the last few years
3. Bond values may have fallen...
This means their expected future returns are now higher than a few years ago. This is good news for those drawing on their investments.
If you are worried about recent market returns and how this might impact the sustainability of your retirement income, please get in touch with us.
The team at Pyrford Financial Planning are highly qualified Independent Financial Advisers based in Weybridge, Surrey. We specialise in retirement planning and provide pension advice, investment advice and inheritance tax advice.
Our office telephone number is 01932 645150.
Our address is No 5 The Heights Weybridge KT13 0NY.
Please note: This blog is for general information only and does not constitute advice. The information is aimed at retail clients only.
Although best efforts are made to ensure all information is accurate, you should not rely on this blog for your personal situation or planning.
The value of your investment can go down as well as up and you may not get back the full amount you invested. Past performance is not a reliable indicator of future performance.