You’ve probably heard the term rebalance. You may even have a vague idea of what it is and what it is supposed to do. But have you wondered how it works, and do you know the right way to do it?

At its most basic level, the practice of rebalancing is intended to ensure that your portfolio stays within a predetermined allocation (i.e. proportion of stocks to bonds). It prevents you from getting overweighted in a particular asset, and ending up with a portfolio that has more (or less) risk than you wanted.

And at that level, it makes a lot of sense. If you have a level of risk that you are comfortable with, and stocks have grown faster than bonds, you probably want to take a profit.

No one ever went broke taking a profit, right?

If only it were that simple. You see, in many cases rebalancing isn’t just about selling risk assets (stocks) at the top to buy more conservative investments (or the reverse if risk assets have fallen).

What actually happens a lot of the time in automated rebalancing strategies is that certain risk assets are being sold to buy other risk assets. Well, that doesn’t necessarily reduce risk now does it?

Another way of thinking about it is that your manager sold your winners to buy your losers.

Well, why would a money manager do this? Because they have been convinced by the academic community that there is a justifiable reason to rebalance this way. And that reason is called mean reversion.

Mean reversion is a fancy sounding phrase that just means if something has recently gone up more than its historical average, you should expect it to underperform so that it eventually converges with its historical average. On the other side, if an asset has been underperforming its historical average, you should expect it to outperform.

Simple enough in theory. Now all you have to do is find an investment that moves in the opposite direction of your first asset, make sure that they both have a long-term positive expected rates of return, and then you’re cooking with gas!

As a side note, there is rarely an investment that moves directly opposite and has a positive expected return, but the experts will tell you it doesn’t have to be perfect for the theory to work.

With this relatively simple assumption, you have justified rebalancing between your recent winners and losers. Not only have you justified it, but by doing it this way, many are convinced that you should expect to increase your return and reduce your risk. In other words, have your cake and eat it too.

In theory, this makes a lot of sense, but as Einstein said,

“In theory, theory and practice are the same. In practice, they are not.”

Here is a chart that shows the last 10 years showing different US stock market indexes that vary in size and style. They are the types of indexes that many managers use as diversifiers.

(It’s a bit of a jumbled mess, but just focus on the annualized returns in the legend.)

So, if your manager spent the last 10 years rebalancing your portfolio by selling large cap growth stocks (the ones that dominate the S&P 500) and buying smaller and value stocks, your performance might have been worse than if you did nothing and your risk (as measured by volatility) potentially increased. That’s because small company stocks and value stocks have higher historical volatility, and as such, are effectively riskier than large company growth stocks.

What if your manager instead sold US and bought international stocks?

Effectively, you got the same result.

So while those in academic community would have you believe that you just need to wait for the outperformance to arrive, you have no way of knowing if it ever will.

How did the basic idea of rebalancing between asset classes became a thing? Financial theories are developed by reviewing past performance.

Yup. Past Performance.

And while you’ve been told your entire investing life that past performance is not indicative of future results, that is all there is to go on. What financial researchers do is study the history of financial markets. They’ll tell you that they can review long-term patterns that go back hundreds or thousands of years (in the case of interest rates).

We can study medical care going back hundreds or thousands of years as well, but I’m not sure you’d want to use much of how Civil War battlefield surgery was performed for managing your health today.

Like medicine, the modern financial markets are relatively new. The S&P 500 was constructed in 1957 and back tested to the 1920’s. It didn’t actually become an investment until 1976 when Jack Bogle created Vanguard. The financial (interest rates/equities) futures markets didn’t start until the 1970’s, and it wasn’t until the 1990’s that index funds were given the authority to use equity futures to help them manage cash flows.

So while researchers can spend their career digging through financial history and data set to come up with reasons that something tends to work, they don’t have enough data to know for sure if it is really statistically significant or just blind luck.

At one conference I attended, a Nobel Prize winning economist told an audience that he just needed 400 more years worth of data to prove that the theory has validity. He was serious. We just don’t have enough data to yet determine if it is skill or luck.

During an interview, the partner of this Nobel Prize winning economist told an audience regarding underperformance of their theory that 10 years was “nothing”. He said it is reasonable to expect periods of underperformance that could last 30 years or more, and that wouldn’t make the theory invalid.

But that lack of confidence on their part hasn’t stopped many from implementing this theory in their investment management process which presumably has them selling growth stocks and buying small and value stocks just waiting for the outperformance to arrive. (Maybe it will, but we can’t know for sure.)

But wait! There’s more!

What else might those clients have experienced aside from potentially lower returns? Well, if they were rebalancing a taxable account, they likely would have had more in taxable income. You see, rebalancing triggers the realization of capital gains, which (depending on your tax bracket) could be taxable. Make no mistake, taxes can have a real impact on your long-term returns.

So, why bother? Is rebalancing wrong? No, rebalancing is an extremely important part of your portfolio management.

This is because if you never rebalance, your best performing asset could (with enough time) come to dominate your portfolio, and most of us can’t handle the risk profile of our best performing asset.

Take for instance Amazon. Let’s pretend that you owned Amazon back in the day and your portfolio had never been rebalanced. Now, in this example, effectively the majority of your money is now in Amazon (because it out performed everything else in your portfolio).

With a 34% annual return since inception, you might be willing to give it a shot, right?

Well, in reality, in order to get that return, look at the number and length of drawdowns from all-time highs that you would have had to endure. And remember, you are looking backwards at what happened. What if all of your retirement money were in Amazon in 2000? Could you have retired?

The reason we diversify and rebalance is because almost no one has the risk tolerance and the financial ability to withstand these types of drawdowns. The bigger the asset becomes and the more important it becomes to us financially, the more important it is that we protect ourselves from financial ruin.

However, you need to make sure that rebalancing your portfolio is having the actual intended effect – maintaining your risk profile, while at the same time giving you the chance to achieve your financial goals.

Following a decades old academic model just because it has been around for a long time is a reason, but it isn’t a good enough reason.

“We just need the courage to question outdated assumptions”
– Ray Kurzweil

Rebalancing between predetermined assets isn’t the right option as risk profiles of asset classes can change. Your process should have the ability to adapt as markets do, and this process should give you the opportunity to keep your portfolio inline with your personal risk tolerance while keeping the taxes you pay as low as possible.

In short, rebalancing is important, but it is also important that it be done in the right way.