Opinion

James Saft

The agony of rebalancing

August 2, 2012

By James Saft

(Reuters) – Portfolio rebalancing is one of those things which sounds sensible until you actually have to do it.

At which point, it usually just seems terrifying.

Portfolio rebalancing — the art of selling what has gone up and buying what has gone down — has a good track record along with lots of research backing up the assertion that it, in aggregate, will improve investors’ portfolio returns.

But the most crucial and high-value opportunities to rebalance usually come at exactly the kinds of times when even rational investors feel like hiding under their desks. Imagine a market crash, where you lose 8 or 10 percent of your portfolio and then, being a sensible investor, realize that right now is the time to sell the bonds that have held their value and load up on equities.

Not easy.

Jason Hsu, chief investment officer at investment advisory firm Research Affiliates, argues that this explains why so many otherwise rational investors, including large institutions, pass on rebalancing at critical junctures.

“When you buy risk assets during economic distress, there is a significant probability that, in the interim, your portfolio may suffer a greater decline than if you didn’t rebalance,” Hsu writes in a note to investors.

“In the short run, your probability of being fired as a fiduciary, of being blamed by clients you advise, and, most importantly, of marital strife, becomes moderately higher when you rebalance.”

So, there you have it: you can rebalance but you have to weigh the benefit against the potential career and personal costs of doing something that can often look like running back into a burning building.

The benefits of rebalancing can only really be judged many quarters, if not years, after the act, and have to be viewed as part of an overall strategy. Buying into a falling market, on the other hand, especially in periods of acute distress, has the very real chance of looking extremely stupid right away.

This is an important point to remember as we sail into an August and autumn which may bring real distress in Europe and upsets in global capital markets.

GOOD EVIDENCE, GOOD ENTRY POINTS

The literature on rebalancing is vast and pretty one-sided. If an asset falls in price and is cheap based on historical experience it has, on average, a better chance of providing superior returns going forward.

John Campbell of Harvard and Robert Shiller of Yale wrote an early paper arguing of the use of dividend ratios to predict future returns in 1998, and presciently, were quite bearish on equities based on how they read the evidence.

Picking entry points can be hard but a disciplined rebalancing strategy does this for you, allowing the market to guide you as to when to buy and when to sell.

TWO-WAY PHENOMENON

This may help to explain both the phenomenon of momentum investors, who pile in when markets are good, and why they can sometimes, at least for a time, outperform. Just as an investor is more likely, psychologically, to go into his shell when suffering losses, so they become more fearless and aggressive when markets are strong.

When portfolio returns are strong, you are perhaps more likely to feel as if you are playing with the “house’s money” and will take on more risk. At the same time, these periods are usually ones in which macro and political news is supportive, making it easier still to allow one’s overweight position in what has already gone up to ride. The wave of money this generates can drive prices and returns, though not forever.

At the same time, beaten-down investors who’ve suffered losses may come to fear that, if they are individuals, they will face difficult lifestyle choices, or if they are professionals, that they may get fired.

To be sure, sometime there is no reversion to mean, and doubtless there are many Lehman Brothers and Bear, Stearns shareholders who are still waiting for the bounce.

So, what to do if we know something is good for us but expect that we will find it difficult to make ourselves eat our vegetables anyway?

Andrew Ang, of Columbia Business School, has argued for what he calls “countercyclical investing,” which he says needs to be institutionalized rather than left to the discretion of managers. This kind of behavioral strategy is promising but deeply unsettling.

It is easy to read the papers and accept that rebalancing works. It will be a lot harder if the euro falls to tatters later this year to hold your breath and buy into risk assets.

(At the time of publication James Saft did not own any direct investments in securities mentioned in this article. He may be an owner indirectly as an investor in a fund. You can email him at jamessaft@jamessaft.com and find more columns atblogs.reuters.com/james-saft)

(James Saft is a Reuters columnist. The opinions expressed are his own.)

(Editing by Lauren Young)

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