• Basic Membership Access to Journal, Shadow Stock portfolio & monthly updates for stock screens
  • A+ Investor Full access to AAII.com, Journal, and a power data suite for investment ideas
  • AAII Platinum Full access to all of AAII's model portfolios and premium services at a significant discount
  • Dividend Investing Newsletter and model portfolio that focuses on dividend growth
  • AAII Growth Investing Find secular growth stocks poised for outperformance regardless of macroeconomic conditions.
  • Retirement Investing Discover trusted strategies for every stage of retirement. Get actionable insights and resources for smart retirement planning.
  • Sentiment Investing A research-driven newsletter with 10+ signals decoding sentiment across retail and institutional behavior.
  • Stock Superstars Report Get stock ideas inspired by the market's leading professionals
  • VMQ Stocks For the value investor looking to harness academic research in an actively managed portfolio
  • Bits and Bips Newsletter delivering insights on linking traditional finance, macro trends and cryptocurrency opportunities to help investors build stronger, more diversified portfolios.
All premium products come with free basic membership.
Explore All Membership Options
Join Now
Portfolio Strategies Rebalancing Transition to Retirement

Rebalancing to Navigate Bear Markets and Sequence Risk

Periodically adjusting allocations back to intended targets lessens the magnitude of swings in a portfolio’s returns.

by Charles Rotblut | March 2023

Charles Rotblut leads a class in AAII's new Essential Investing Video Course. Go to https://www.aaii.com/ves for more information and to subscribe.

Featured Tickers:

Last year’s negative returns in both the equity and fixed-income markets were an example of sequence risk. The negative returns also provided a real-time test for investors of their ability to withstand downside risk from a financial and psychological standpoint.

Rebalancing is one strategy that investors who find themselves more averse to downward volatility can employ to channel their emotions while maintaining progress toward longer-term goals. Rebalancing adjusts a portfolio’s allocations back to target. It gives an investor something positive to do when market turbulence occurs.

Rebalancing can also help investors who either are or will soon be taking withdrawals, such as retirees and those approaching retirement age.

In this year’s update to my ongoing analysis of rebalancing strategies, I look at the impact sequence risk has had on more recent portfolio returns. Analysis of rolling 25-year periods is shown for portfolios based on the AAII moderate portfolio allocation. This year, we’ve expanded the analysis to include portfolios following the AAII aggressive portfolio allocation model.

Before getting into the details, here are a few takeaways:

  • Sequence risk affected the returns over the latest 25-year period.
  • The ending equity allocation for the non-rebalanced withdrawal portfolio following the moderate allocation was greatly diminished by not rebalancing.
  • Even when an aggressive allocation is used, a strategy for navigating bear markets is still very important for those who are taking withdrawals.

Sequence Risk Reared Its Ugly Head

Sequence risk refers to the chance of incurring ill-timed negative returns. It matters far more to those who currently need/will soon need to take withdrawals than to investors who won’t need to take withdrawals for the foreseeable future.

Last year, investors were hit with negative returns for both stocks and bonds. This is just the sixth such occurrence of both falling in the same calendar year since 1878, according to Doug Ramsey at the Leuthold Group.

The impact of the drop in both asset classes can be seen in the ending portfolio balances for the rolling period analyses. As measured by ending value and annualized return, both moderate and aggressive allocation portfolios experienced their worst 25-year period ending in 2022 since the analysis started. (Our analysis starts in 1988 because it is the first year that full-year returns are available for some of the Vanguard mutual funds used.)

Not apparent in the portfolio data is the sequence risk bonds have experienced. Here are the returns the Vanguard Total Bond Market Index fund (VBTLX) has realized over each of the past 10 years (2013–2022): –2.3%, 5.8%, 0.3%, 2.5%, 3.5%, –0.1%, 8.7%, 7.7%, –1.7% and –13.2%. Returns for the bond fund were below 5% during seven of the last 10 calendar years. Returns were negative four times: 2013, 2018, 2021 and 2022.

Equities posted negative returns during two of the past five years (2018 and 2022).

Rebalancing’s role is to preserve a portfolio’s target allocation, reduce volatility and give a nervous long-term investor a positive emotional outlet. Our analysis shows that rebalancing softens the edges of market volatility. The rebalanced portfolios realized less volatility and better maintained allocations throughout most of the 11 rolling 25-year periods.

Portfolios and Allocations Used to Test Rebalancing

My analysis of rebalancing is based on hypothetical portfolios using the AAII moderate investor Asset Allocation Model and—in response to requests for a more equity-heavy portfolio—the AAII aggressive investor Asset Allocation Model.

The moderate allocation model modifies the traditional 60% equity/40% fixed-income allocation strategy by incorporating greater diversification on the equity side and a shorter duration (meaning less interest rate sensitivity) on the bond side. Specifically, the model calls for allocating 20% to large-cap stocks, 15% to mid-cap stocks, 10% to small-cap stocks and 15% to international stocks. On the bond side, it calls for a 30% allocation to intermediate-term bonds and a 10% allocation to short-term bonds. (An intermediate-term bond fund is used in the rebalancing models.)

The aggressive allocation model has 90% in equities and 10% in fixed income. The model calls for allocating 20% to large-cap stocks, 20% to mid-cap stocks, 20% to small-cap stocks, 20% to international stocks and 10% to emerging markets stocks. On the bond side, it calls for a 10% allocation to intermediate-term bonds.

Figure 1 shows the characteristics and hypothetical returns for the three allocation models.

FIGURE 1 AAII Asset Allocation Models

The portfolios use Vanguard mutual funds to replicate the returns an investor could have realized after fund fees are factored in. The Investor shares class of funds was used for the period of 1988 through 2017. The Admiral shares class of funds was substituted in 2018 because Vanguard stopped offering the Investor shares class to most investors. Part of the goal of this study is to show the returns an investor could have realized in a real-world portfolio, gross of taxes and specific account fees.

Eleven rolling 25-year period models are the subsets, with starting dates ranging from 1988 to 1998.

The hypothetical portfolios are either non-withdrawal or withdrawal. As the name implies, no withdrawals are taken out of the non-withdrawal portfolios.

The withdrawal portfolios assume that a retiree makes annual withdrawals based on an inflation-adjusted 4.5% rate. A withdrawal equal to 4.5% of the portfolios’ balance at the end of the first year is taken. This initial withdrawal rate is then increased each year by the rate of inflation. The strategy is based on research by retired financial planner William Bengen. (Required minimum distributions, or RMDs, were not used because age, account type and life expectancy would impact the calculation of the withdrawal rate.)

The year-over-year change in the consumer price index for all urban consumers (CPI-U) is used to determine the inflation adjustment. This benchmark can be substituted with a different measure.

Withdrawals were taken evenly from each of the funds in the moderate allocation portfolios. In the aggressive allocation portfolios, 10% of the withdrawal amount was taken from the bond fund and the remaining 90% evenly taken from the equity funds.

Rebalancing took place whenever a specific allocation was more than five percentage points above or below its target at year-end. This threshold band is based on research by Vanguard. It allows the portfolio to benefit from short-term momentum in asset class groups while not straying too far from its targeted allocation.

Rebalancing Helped the Moderate Allocation Portfolios

The benefit rebalancing had when sequence risk occurred can be seen in Tables 1 and 2. These tables show 25-year returns for the moderate non-withdrawal and withdrawal portfolios.

TABLE 1 Moderate Allocation Non-Withdrawal Portfolios 25-Year Rolling Periods

TABLE 2 Moderate Allocation 4.5% Withdrawal Portfolios 25-Year Rolling Periods

For the latest rolling period (1998–2022), the rebalanced portfolios had larger ending balances under both the non-withdrawal and the withdrawal strategies. There are different reasons for this.

The non-rebalanced, non-withdrawal portfolio ended 2021 with an 80.1% allocation to equities versus a 68.4% equity allocation for the rebalanced, non-withdrawal portfolio. This made the non-rebalanced portfolio more sensitive to a drop in equities prices in 2022. All four of the equity funds used fared worse than the bond fund in 2022. The reduced volatility of the rebalanced portfolio helped its return.

The big problem for the non-rebalanced withdrawal portfolio was the combination of withdrawals and early sequence risk. The timing of the dot-com bust coincided with rising withdrawal amounts. This drained dollars from those positions. The subsequent timing of the 2008 bear market compounded the problem and the portfolio never recovered. Its equity exposure at the end of 2022 was a mere 30.2%.

The rebalanced withdrawal portfolio did not experience this issue since the periodic rebalancing preserved the allocation. This portfolio was rebalanced nine times—including four out of the five years between 1999 and 2003.

The lesson for soon-to-be/new retirees is to have a plan in place to deal with sequence risk. Besides direct rebalancing, the withdrawal strategy could have been adjusted to avoid selling shares from positions incurring a large loss. The size of withdrawals could have been reduced too.

In terms of all rolling periods, rebalancing led to higher returns than not rebalancing during five of the 11 rolling periods for the non-withdrawal portfolios and reduced the level of volatility during all 11 rolling periods. On the withdrawal side, the rebalanced withdrawal portfolios realized higher returns during nine of the 11 rolling periods compared to their non-rebalanced counterparts. Volatility was lower during nine of the 11 rolling periods.

Rebalancing Reduced Volatility and Returns for the Aggressive Portfolios

Tables 3 and 4 show the 25-year rolling returns for the aggressive non-withdrawal and withdrawal portfolios.

TABLE 3 Aggressive Allocation Non-Withdrawal Portfolios 25-Year Rolling Periods

TABLE 4 Aggressive Allocation 4.5% Withdrawal Portfolios 25-Year Rolling Periods

Rebalancing led to lower volatility than not rebalancing for the aggressive non-withdrawal portfolios during all 11 periods. This was because rebalancing preserved the bond allocation. The non-withdrawal rebalanced portfolio ended 2022 with an equity allocation of 91.8% for instance. Its non-rebalanced counterpart ended 2022 with a 95.6% allocation to equities.

Rebalancing only outperformed not rebalancing during the period of 1991–2015 for the non-withdrawal portfolios. By allowing the equity allocation to rise in the non-rebalanced portfolio, returns improved but volatility increased as the original allocation was abandoned.

Not rebalancing also led to both higher returns and higher volatility for the withdrawal portfolios compared to rebalancing. Withdrawals had an impact that went beyond what is shown in Table 4, however. As a reminder, 10% of the annual withdrawal amount was taken from the bond allocation, with the remainder evenly taken from the equity funds.

Consider the latest rolling period (1988–2022). Both the large-cap stock and bond fund positions were close to being completely drained at the end of 2022 in the non-rebalanced withdrawals portfolio. This is due to a function of the returns for both of these funds relative to those of the other three funds, the sequence in which those returns occurred and how withdrawals were being taken.

The Level3 withdrawal strategy, which allocates up to four years’ worth of withdrawals to defensive assets, could have been used as an alternative to the rebalancing strategy used for this article. Withdrawals would have come out of the defensive allocation (cash equivalents or short-term bonds) from 2000–2003 as well as at year-end 2008, 2018 and 2022. Withdrawals for all other years would have come from the equity allocation.

This strategy also requires some rebalancing. The defensive asset allocation (cash equivalents or short-term bonds) would have needed replenishment following those down years. However, this strategy would have allowed an investor to better navigate the sequence risk of the past 25 years than simply not rebalancing at all.

Where Rebalancing Has the Biggest Impact

As we have shown in past updates, rebalancing is most beneficial to investors who wish to maintain an allocation, find themselves unnerved by downside volatility in the markets and/or are taking withdrawals.

Rebalancing lessens the magnitude of swings in a portfolio’s returns and gives investors something positive to do during periods of market turbulence. The combination can make it easier to maintain a larger allocation to stocks over the long term.

In the withdrawal stage, rebalancing preserves the portfolio’s diversification over longer periods. A modified version of rebalancing can be undertaken by adjusting the withdrawals each year in a manner to maintain the allocation. This would be akin to annual rebalancing. However, depending on the size of the withdrawals, it may not be enough to fully preserve the allocation. 

Discussion

RICHARD A from FL posted over 3 years ago:

I believe most important is to have at least 3 to 5 years in the brokerage money market to cover RMD's in a down market so we are not selling equities or bonds at a loss.


GARY F from KY posted over 3 years ago:

What is the starting value of the portfolio? I may have missed it....Gary


CHARLES R from IL posted over 3 years ago:

Hi Gary,

All portfolios were started with a balance of $100,000.

-Charles


BARRY J from TX posted over 3 years ago:

Charles, this article reinforces how hard the AAII staff works to educate IIs. It places the impact of “annus horribilis ” 2022 in a historical context and provides measures we can use to estimate the value provide using an annual rebalancing process. I get the gist: diversification, annual rebalancing, and planned withdrawals pay off when the market blows a circuit breaker. However, it is unclear exactly how much rebalancing pays off. A table at end of the article listing the average differences for both the ending balances (portfolio growth) and standard deviations (variation) for each section of each of the four tables would help us appreciate the magnitude of the payoffs from all this annual planning and appreciate the significance of this article’s promise - ”Periodically adjusting allocations back to intended targets lessens the magnitude of swings in a portfolio’s returns.” My quick math on the differences between the ending amounts for each of the portfolio alternatives is Table 1 60/40 0% WD = 0.81% favoring rebalancing, Table 2 60/40 4.5% WD 0.14 favoring rebalancing; Table 3 80/20 0%WD 0.218 favoring no rebalancing, and Table 4 80/20 4.5% WD 0.419 favoring no rebalancing. (Note: I did not compute the total value of annual withdrawals). This math shows the approximate rewards from active portfolio management. I would have computed the estimated cost of having all this work done through using actively managed accounts, but I was too lazy to do that. Maybe one of the other members can do that for us. This presents an excellent opportunity to make the case for active managed investing … or not. Any takers?


BARRY J from TX posted over 3 years ago:

I love this article. Thank you, Charles. There is so much here to think over. #1 “As measured by ending value and annualized return, both moderate and aggressive allocation portfolios experienced their worst 25-year period ending in 2022 since the analysis started.” #2 This sentence explains one of the causal factors. “The big problem for the non-rebalanced withdrawal portfolio was the combination of withdrawals and early sequence risk. The timing of the [1999-2001] dot-com bust coincided with rising withdrawal amounts. This drained dollars from those positions. The subsequent timing of the 2008 bear market compounded the problem and the portfolio never recovered. “ These conclusions stood out to me as a good operational definition of “sequence risk” and its destructive impact. It provides confirmational evidence of AAII founder Cloonan’s important distinction between seeing portfolio volatility (standard deviation) as the “risk” to focus on versus focusing on the “real risk” defined as loss of principal when you need it. (Source: “Investing at Level3: Higher Returns With Minimal Risk for the Long Term Individual Investor,” James Coonan. This analytical approach and the historical data projected forward imply that the 25-year rolling sequences will include the 2008-2009 recession (through 2033) and the impact of “the worst year in 25 years” -- 2022 --- in all sequence risk analyses through 2047. This is not a fun prospect. Some of us may ask what the 1999-2001 "dot.com bust," the 2008-2009 “Great Recession,” and the 2022 “worst year” have in common. I see some connections in contemporaneous fiscal and monetary policies. Comments?


ROBERT A from NC posted over 3 years ago:

I have two takeaways. First, EVERY SINGLE ending portfolio value was higher for the "aggressive" portfolio than for the contemporaneous "moderate" portfolio. (Thus, I no longer care what happens with the moderate portfolios.) Second, for EACH of the aggressive portfolios, NOT rebalancing led to significantly higher ending values for 10 out of 11 of them. Since I'm only interested in long-term returns and don't give a whit about volatility, this article reinforces the prudence of my 100% allocation to equities and tells me to forget rebalancing. Well done!


ROBERT A from NC posted over 3 years ago:

From the article: "Even when an aggressive allocation is used, a strategy for navigating bear markets is still very important for those who are taking withdrawals." Well, I can tighten my spending somewhat. Other than that, I can hunker down and ride out the storm. I'm not sure what else I could do.


JOHN L from NJ posted over 3 years ago:

Robert A - You can sell some of your stocks when the market is down. There seems to be a popular but untrue assumption that selling a small percentage of stocks when the market drops leads to ruin. Looking at rolling 30 year periods since 1872; a 100% equity portfolio and pulling out the same real amount each year outperforms any combination of bonds and equity for all 30 year periods. If you have the emotional fortitude to stick with 100% equity; you will do better than adding bonds and trying to time the market using a bucket strategy.


ROBERT A from NC posted over 3 years ago:

John L, I 100% agree with you! In fact, I keep no more than 3 months of cash on hand at any time. Dividends and occasional small sales take care of my needs and wants. Selling when the market is down merely reduces the gains on which I pay taxes. And considering that since retirement I've never had to sell more than 1% of my assets to meet expenses in any given year, the market would have to be down a LONG time to "ruin" me.


J J from WI posted over 3 years ago:

Why are the total withdrawals for both no re-balance and re-balance identical, to the dollar, in both Table 2 and Table 4 even though the everything else is different? Also if you look at the best ten year sector return for any bond ETF from the February 2023 AAII magazine it is 2.7 percent for the high yield sector. ( It can be as small as 0.4 percent for the long term bond sector). That compares to a utility sector return of 9.9 percent for ten years. (I'm assuming those returns are for total returns with dividends reinvested). Using the Rule of 72, it would take almost 27 years to double your money using the best bond return. But only a little more than 7 years using the utility ten year return. So you wouldn't even double your money in 25 years using the best bond ETF. But you get better than an eight fold increase in the Utility ETF. I would much rather use utility stocks rather than bonds.To me, bonds are a safe way to lose money, especially when you factor in inflation!


CHARLES R from IL posted over 3 years ago:

JJ,

For the withdrawals, I assumed an inflation-adjusted 4.5% withdrawal rate based on the starting balance of $100,000 for both portfolios. The only change in the withdrawal amount each year was the annual increase in the consumer price index (CPI).

-Charles


J M from NJ posted over 3 years ago:

This is a very insightful and useful article. However, the returns shown for the withdrawal portfolios in Tables 2 and 4 appear to be grossly understated. For example, looking at the data shown in the first row of table 4 for the period 1998-2022, the investment return is listed as 45%. This was computed as a gain of $45,000 by subtracting the $100,000 starting portfolio value from the $145,000 ending portfolio value. However, the total portfolio withdrawals are listed as $172,769. How is it possible to generate $172,769 of withdrawals if the investment return is only $45,000? I believe the portfolio withdrawals need to be added to the $45,000 investment returns to arrive at the correct return. The correct investment return should be $179,769 + $45,000, which equals 217,769, or 217% of the $100,000 starting portfolio value. This calculation error has appeared in several previous versions of the article and yet the error persists. It would be helpful if AAII could provide corrected tables or an explanation as to why the returns shown in the withdrawal portfolios are correct.


CHARLES R from IL posted over 3 years ago:

Hi J,

We've left the withdrawal amounts out of the return calculations to better show the impact rebalancing has on ending wealth.

-Charles


J M from NJ posted over 3 years ago:

Thanks for your reply. The returns of the withdrawal portfolios are likely to mislead to the reader as I don't see that fact is not noted anywhere in the article. The primary reason I like the tables in this article has nothing to do with rebalancing. The tables are most useful to me in illustrating that the returns of withdrawal portfolios are substantially less than returns of a non-withdrawal portfolios which is of high interest to retirees like me. Because the withdrawals aren't being included in the returns, the tables are less useful in understanding the actual difference in returns between the withdrawal and non-withdrawal portfolios. I wonder how many retirees are aware of the fact that they cannot expect compounded market like returns when withdrawing from their portfolios. I was absolutely floored when looking at earlier versions of this article when I first discovered that a retiree drawing down a portfolio can only expect something like 60% to 70% of the returns of the non- withdrawal investors. I will do my own calculations to quantify and update those estimates based on your latest data.


CRAIG B from WI posted over 2 years ago:

I've been educated that rebalancing too frequently can result in missing one of the most important (and unpredictable) market forces: momentum. Going with winners longer until valuation reaches your 'x' out level, mimics more closely what small business do with almost all of their investible assets. They concentrate it (huge risks) but the tremendous rewards of keeping the assets invested completely pay off in successful businesses. I use mostly standard index funds but also 'tilts' to increase exposure to sectors clearly outpacing the field. QQQ, FDN and going forward perhaps even BOTZ along with standard XLV, XLE and XLU are watched even more closely for adjustments as I am in full retirement. The Bucket Strategy works well for us and 3 years of cash, as the above reader emphasizes, is a key to it. The article does well to remind us to watch allocations and when they far exceed our plan's levels as well as standard benchmarks it's time to rebalance, more easily done in tax-sheltered accounts than taxable ones but I never allow taxes to dominate my investment decisions.


You need to log in as a registered AAII user before commenting.
Create an account

Log In

Get your free copy of our special report analyzing the tech stocks most likely to outperform the market.
Download the FREE Report Here: