Show clients how portfolio rebalancing helps to manage risk

March 10, 2020 | Vanguard Perspective

Show clients how portfolio rebalancing helps to manage risk

Advisors recognize the value of periodic portfolio rebalancing to maintain their clients' target asset mix. After all, asset allocation has been shown to be the most important factor in determining long-term investing success.1

Yet clients often express resistance to the idea of rebalancing their portfolios. One of their most common objections: Why sell the winners and buy more of the assets that have less impressive returns? Why not do the precise opposite to reap maximum returns?

You can use our customizable guides to walk clients through the answers to those questions.

Historically, higher-return assets have brought increased risk

Best, worst, and average returns for various stock/bond allocations, 1997–2019

Chart depicting the high and low returns for 11 different hypothetical portfolios from 1997 through 2019. Along the x-axis, the asset allocation of the portfolios ranges from 0% stocks and 100% bonds to 100% stocks and 0% bonds. Along the y-axis lies a range of investment returns, from –50% to 50%. At a 100% bond allocation, the maximum return was 12.1%, while the worst return was –2.1%. As the allocation to stocks increased (and the allocation to bonds decreased) across the portfolios, the best return for the period also increased (to 35.1%), as did the worst loss (to –40.4 %). Thus, the chart demonstrates that, in the past, higher-return assets such as stocks were accompanied by higher risk.

Past performance is no guarantee of future returns. The performance of an index is not an exact representation of any particular investment, as you cannot invest directly in an index.

Source: Vanguard, as of December 31, 2019.

Notes: Stock allocation consists of 60% U.S.-domiciled equities and 40% equities domiciled outside the United States. Bond allocation consists of 70% U.S.-domiciled fixed income securities and 30% fixed income securities domiciled outside the United States. U.S. stocks are represented by the Dow Jones Wilshire 5000 Index from 1997 through April 22, 2005, and the MSCI US Broad Market Index thereafter. International stocks are represented by the Total International Composite Index through August 31, 2006; MSCI EAFE + Emerging Markets Index through December 15, 2010; MSCI ACWI ex USA IMI Index through June 2, 2013; and FTSE Global All Cap ex US Index thereafter. U.S. bonds are represented by the Bloomberg Barclays U.S. Aggregate Bond Index. International bonds are represented by the Bloomberg Barclays Global Aggregate Float Adjusted Composite Index.

Over time, different asset classes have produced different returns and, correspondingly, different levels of volatility.

More portfolio return consistency through balance

Annual returns by asset class, from the highest to the lowest, 1997–2019

Chart  showing, in a matrix format, the returns of various asset classes from 1997 to 2019. The asset classes include U.S. equity, real estate investment trusts (REITs), a balanced portfolio of 60% stocks and 40% bonds (60/40), U.S. bonds, cash investments, global bonds, global stocks, commodities, and emerging markets equity. In the period, the 60/40 portfolio delivered the third-best performance, a 6.91% average annualized return, while exhibiting less volatility (indicated by heightened variability of returns year-to-year) than the two higher-performing asset classes.

Past performance is no guarantee of future returns. The performance of an index is not an exact representation of any particular investment, as you cannot invest directly in an index.

Source: Vanguard, as of December 31, 2019.

Note: Cash is represented by the FTSE 3-Month U.S. Treasury Bill Index. REITs are represented by the MSCI US REIT Index adjusted to include a 2% cash position (Lipper Money Market Average) through April 30, 2009, and MSCI US REIT Index thereafter. U.S. equity is represented by the Dow Jones Wilshire 5000 Index through April 22, 2005; MSCI US Broad Market Index through June 2, 2013; and CRSP US Total Market Index thereafter. Emerging markets equity is represented by the Select Emerging Markets Index through August 23, 2006; MSCI Emerging Markets Index through January 9, 2013; FTSE Emerging Transition Index through June 27, 2013; FTSE Emerging Index through November 1, 2015; FTSE Emerging Markets All Cap China A Transition Index through September 18, 2016; and FTSE Emerging Markets All Cap China A Inclusion Index thereafter. U.S. fixed income represented by Bloomberg Barclays U.S. Aggregate Bond Index through December 31, 2009, and Bloomberg Barclays U.S. Aggregate Float Adjusted Index thereafter. Global fixed income represented by Bloomberg Barclays Global Aggregate ex-USD Float Adjusted RIC Capped Index (USD Hedged). Global equity is represented by the Total International Composite Index through August 31, 2006; MSCI EAFE + Emerging Markets Index through December 15, 2010; MSCI ACWI ex USA IMI Index through June 2, 2013; and FTSE Global All Cap ex US Index thereafter. Commodities are represented by the Bloomberg Commodity Index. Composite 60/40 portfolio’s equity allocation consists of 60% U.S.-domiciled stocks and 40% non-U.S. domiciled stocks; bond allocation consists of 70% U.S.-domiciled bonds and 30% non-U.S. domiciled bonds.

Gaining buy-in from clients for strategies such as rebalancing can be as simple as providing them with a "why" that answers their questions or satisfies their objections. For instance, they may want to know more about your firm's rebalancing methodology—what is the process, how often does it happen, does it usually result in significant capital gains taxes or transaction costs, and how significant a risk reduction can they expect in return?

In considering these conversations, you might find Vanguard's rebalancing-related research to be a helpful reference.

Advisors have a range of options with which to approach rebalancing:

Time only—rebalancing on a set schedule, such as daily, monthly, quarterly, or annually.

Threshold only—rebalancing when a target asset allocation deviates by a predetermined percentage, such as 1%, 5%, or 10%.

Time and threshold—rebalancing on a set schedule, but only if a target asset allocation deviates by a predetermined amount, such as 1%, 5%, or 10%.

Many advisors use rebalancing software to eliminate any uncertainty over which option might yield the best outcome. Otherwise, the chosen approach can simply hinge upon your practice's preference.

By way of example, Vanguard performs a quarterly rebalancing review with advised clients. The Vanguard advisor analyzes a computer-generated report of investment recommendations for a client's portfolio, including recommended changes if the portfolio exceeds the target allocation by more than 5%. The advisor receives notification of the rebalancing activity and can discuss the changes with the client.

Rebalancing can also be combined with and complement other strategies, such as tax-loss harvesting. Vanguard research shows that advisors can add appreciable value over time, through activities such as rebalancing and behavioral coaching in general.2

In addition, Vanguard research has determined that none of the major rebalancing approaches holds a distinct or enduring advantage over the others. Therefore, the most important consideration is for advisors to apply rebalancing to client portfolios in a consistent and disciplined manner to give clients the best chance of reaching their long-term financial goals.

 

1 Gary P. Brinson, L. Randolph Hood, and Gilbert L. Beebower, 1995. "Determinants of portfolio performance." Financial Analysts Journal 51(1):133–8. (Feature Articles, 1985–1994.)

2 Francis M. Kinniry Jr., Colleen M. Jaconetti, Michael A. DiJoseph, Yan Zilbering, and Donald G. Bennyhoff, 2019. Putting a value on your value: Quantifying Vanguard Advisor's Alpha®. Valley Forge, Pa.: The Vanguard Group.

Notes:

  • Please remember that all investments involve some risk. Be aware that fluctuations in the financial markets and other factors may cause declines in the value of your account. There is no guarantee that any particular asset allocation or mix of funds will meet your investment objectives or provide you with a given level of income.
  • Diversification does not ensure a profit or protect against a loss.
  • Investments in bonds are subject to interest rate, credit, and inflation risk.
  • Investments in stocks or bonds issued by non-U.S. companies are subject to risks including country/regional risk and currency risk. These risks are especially high in emerging markets.