Pros & Cons of Portfolio Rebalancing


There are some very good posts in this forum that discuss portfolio rebalancing and asset allocation, so I encourage you to read those before you read this one. This post is a teeny bit more advanced than they are and it's intended to follow both.

In this post, I'd like to touch upon a very small sliver of one of the potential pitfalls of rebalancing and how you can overcome that pitfall. But first, let me say that asset allocation combined with portfolio rebalancing is an incredible strategy to reduce risk and to grow your investments. While you may think that you should buy up those hot stock picks with all your money to get the biggest returns, you'll be thankful you didn't when the stocks ebb and flow and potentially force you to sell. It really is all about diversity and risk aversion and that's what both of the aforementioned concepts try to manage.

Let me give you a personal example to make my point of this post. Back a few decades ago, when I first began investing, I thought that all I needed to do was to purchase a few stocks or ETFs. There was so much information on both that I was really overwhelmed. I had heard about various investment strategies, but I never really took any seriously. When it came time to buy some assets, I took a shot in the dark. As you can well imagine, things didn't go so well. I had no idea what short or long term investing was and I really didn't have any goals in mind. All I did have was a small pile of cash and some knowledge that I needed to put that cash into something so it wouldn't get eaten away by inflation. So a few random stocks it was.

Years later, I discovered asset allocation and portfolio rebalancing. It was at this time when I began purchasing a very basic stock ETF as well as a just as basic bond ETF. If you're curious, I bought VOO and BND, just like pretty much everyone else out there does. At the time, I believe I had a 60% stock and a 40% bond mix. As time went by, I noticed that the percentage of each holding either went down or up and as time also went by, I bought and sold portions of these investment according to the fundamentals of portfolio rebalancing.

Now here's where things get interesting. During the time I had initially purchased these investments, the longest running in history equity bull market was taking place in the stock market. Equities were flying higher and higher as each month passed while bonds were growing, but not nearly as much as stocks were. My equity ETF, VOO, was gaining value rapidly while my bond ETF, BND, was gaining value, but not as fast. For the sake of example, let's say that VOO was growing at 20% per year while BND was growing at 5%, which as you can imagine was throwing my asset allocation out of whack.

So here it is; since I had to continuously rebalance my accounts to realign my 60/40 mix of assets, I spent a lot of money on transaction costs. I didn't like that very much. Also, since the equity market was growing so much more rapidly than the bond market was, I didn't really enjoy selling off my high performing and value gaining equity ETF only to purchase a lesser performing bond one. What I was doing seemed counter intuitive to my investing goals. If I had simply left things alone, I could have made a lot more money.

Now, the reason I was okay with this at the time was that I thought the market was in a bubble. Equities were growing, but I felt that they'd soon come crashing down and when that happened, I'd have saved myself a lot of money by selling so much off before that happened. I'd have all these safe bonds and hardly any equities and I'd be in great shape. Well, unfortunately the equity crash didn't happen. What did happen was that they kept on climbing and they're still climbing today. I honestly don't think they'll ever come down due to all of this market manipulation by the central banks of the world. The amount of cash in the global system is growing and growing.

The question now is, how do we effectively rebalance our accounts without selling off our high performers? Well, I figured this out long ago and a great many folk out there seem to agree. The trick is to incorporate dividend paying ETFs, such as VYM, into the mix so that when it comes time to rebalance, all you need to do is purchase the lesser performing asset with the dividend proceeds. VYM is a great dividend payer and BND isn't terrible in its own right. So, if the percentages of my portfolio change to 70/30 because of the growth of equities, then all I need to do is continue to purchase BND with the dividends I earn. This will keep the ratio stable. And if you think about it, if you purchase your ETFs this way, you'll always be buying low, which is obviously the goal with any investment.

If you'd like to read up on this topic, here are two articles I recommend:

Also, if you have any investment suggestions or advice, I invite you to reply to this post down below. I'd love to hear from you.
Pros & Cons of Portfolio Rebalancing was posted on 08-12-2020 by 15Katey in the Finance Forum.