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Why We Don’t Rebalance

by Jason Hsu

Why We Don’t Rebalance Splash image

For investors, the $1 million question is, “Why don’t all of us rebalance?”

Research shows compellingly the long-term benefit of rebalancing, yet anecdotal evidence suggests that most investors do not rebalance their portfolios—that is, buy assets that have become cheap and sell assets that have become expensive. In fact, many investors do the exact opposite!

Why is it so hard for investors to rebalance? The answer is less about “behavioral mistakes” than the fact that “rational” individuals care more about other things than simply maximizing investment returns. Perfectly rational individuals exhibit changing risk aversion that makes it hard for them to rebalance into high return assets that have suffered steep recent price declines. The unwillingness to buy low and sell high is not characteristic of just individual investors who are unaware of the finance literature and market history. Very sophisticated institutional investors, advised by investment consultants and academics, are prone to the very same behavior.

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Jason Hsu is chief investment officer at Research Affiliates LLC and an adjunct professor of finance at the UCLA Anderson Business School.


Discussion

David from Pennsylvania posted about 1 year ago:

Tax consequences do play a role in rebalancing. by taking gains in an up market to buy lower yielding investments is indeed difficult.


Edward Wiltgen from South Dakota posted about 1 year ago:

I think re-evaluation every 6 mos is worth consideration because the market tends to run more positive from Nov to May and more negative May to Nov.


Mark Henwood from California posted about 1 year ago:

I find the consequences of taxes to be a major disincentive to rebalancing, particularly when the effect of rebalancing on portfolio return is so small.


Norman Fulton from Ohio posted about 1 year ago:

Losses from taxes is the number one problem with rebalancing as mentioned above. The second problem is loss of income from the dividends of the sold stocks. If AAII publishes this article again, it would be good to add discussion of these aspects. I really don't want to trade stocks yielding say 15% with stocks yielding 3% or bonds yielding 0%


Jon Silverberg from New York posted about 1 year ago:

It would be useful for Mr. Rotblut and Mr. Hsu to have a give and take about the conclusions of each other's articles and the implications for a strategy going forward.


Jeff Ransom from New Jersey posted about 1 year ago:

Higher tax impacts from selling appreciated equities are further "aggravated" by the progressive nature of those increases: bracket creep and the AMT, which is still unresponsive to inflation. As in any strategy, blind compliance to reallocation must be moderated by specific, real-world details, and some personal financial timing is indicated. Tools which take into account all these effects would be welcomed aids to compare various tactics possible at any point.


Stephen from Pennsylvania posted about 1 year ago:

Re-balancing sounds good as a strategy, but I do not find it offers much for me. As a retiree, I need dividends from stocks and interest from bonds. Even if a stock becomes "over-priced", but it pays a reasonable dividend, I see no reason to sell it. However, if the dividend is reduced or deleted, that stock is mostly or altogether gone. It is more important to me to distribute my stocks over a wide variety of industries and companies than to worry about re-balancing. For bonds, I don't play "ladder" games. I am looking for reasonably priced bonds with decent yields, and I am content to buy long bonds. At my age (74), I cannot worry about paying a premium today, then suffering a loss when the bond matures. I probably won't be around anyway. In any event, I have stopped buying bonds for now, because I do feel that interest rates will begin to rise soon. Many or most may not agree with my investment strategies, but they have worked for me over many years, in good times and bad.


Dave Gilmer from Washington posted about 1 year ago:

Stephen,
I agree pretty much with your strategy, but I stress more dividends for income and index funds for equity growth. The rebalance strategy usually works better if you have a bond/stock allocation, but mainly to keep your risk constant and not really as a way to improve your total return.


John Borden from California posted about 1 year ago:

Other than some comments above, I seldom hear any discussion about the tax implications of rebalancing a taxable portfolio. IRAs are easy to rebalance. Not so with taxable portfolios. Last year I fell for the "you must rebalance yearly" mantra. I sold several ETFs that had done well but fell out of favor with the market. The sale resulted in a 15% federal tax in addition to a 9.3% state tax (California treats L.T. capital gains as ordinary income). That was a 24.3% tax "hit" on my gain. Some say "pay the taxes with other money". Excuse me. That "other money" was potential investment money. I am now researching a buy-and-hold taxable portfolio anchored with a Vanguard S&P 500 fund. Any thoughts?


Paul Hopler from Virginia posted about 1 year ago:

Charles Rotblut a vice president at AAII and editor of the AAII Journal made clear that rebalancing will reduce risk (variability) and without re-balancing stocks will overwhelm bonds. However, if variability is not a problem, and the trend is to stocks, then why on earth would anyone rebalance. If I get 10% variability and 12% growth is this not better then 1% percent variability and 11% growth?


Robert Hooke from California posted about 1 year ago:

Tax consequences can be even greater due to the AMT.
I calculated the following for a high income ($200k) couple with a marginal rate of 32.5% including AMT.:
Income tax %:
short term gains 32.5% + 9.3% CA = 41.5%
long term gains 21.5% + 9.3%= 30.8%
Qualified Dividends 21.5% + 9.3% = 30.8%
all other taxable income 32.5% + 9.3% = 41.5%

I'd think long & hard before "rebalancing" especially for high dividend stocks.


William Lawrence from New York posted about 1 year ago:

I'm with Stephen (who is in my age cohort) on this. I have mostly good old boring dividend-paying stocks that don't exhibit a whole lot of volatility. But since I don't draw down on principal (or on principle) I frankly don't worry about volatility, and the rather marginal advantage afforded by rebalancing after taxes doesn't make it any more attractive than my (mostly) buy and hold approach.


Crescentia Szerlip from California posted about 1 year ago:

Well, aside from tax consequences, which are a major factor, it's hard to grit your teeth and sell into a rising market, and you have no assurance that your replacement stocks will do well.


Dave Gilmer from Washington posted 12 months ago:

The opening comment, "why don't we rebalance," seems a little mis-leading to me. Anyone who is contributing to their 401k or other account on a monthly basis is certainly rebalancing their account by the simple mechanism of dollar cost averaging.

I am using good old boring dividend paying stocks as well in retirement for 100% of my income.

I have always thought that the benefits of rebalancing were dubious at best - in most cases this means trading higher return equities for lower return bonds. It does keep your risk profile intact, but it also lowers your long term returns.

fd


Harry McCullough from Pennsylvania posted 11 months ago:

Apparently the consensus here is tax rates, already historically low, are going to go down. So I guess there also agreement that ROTH's are a bad idea.
Doesn't rebalancing play a role in maintaining not just an allocation but also diversification? The biggest reason for not selling Enron was they didn't want to pay the big tax bill.
I don't hear it much, but according to the text books, taxes should take a back seat to investment decisions.


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