During turbulent markets, you might notice your portfolio veer from its asset allocation targets—and you might feel tempted to rebalance more frequently than normal.
But according to Tony Davidow, asset allocation strategist at the Schwab Center for Financial Research, that’s a temptation you may want to resist.
Yes, market swings can shift your portfolio allocations quickly and unexpectedly, but reacting to short-term volatility is often unwise. Rebalancing tends to work best when you stick to a disciplined strategy. “Strong emotions are rarely the best guide for making smart investment choices,” Tony says.
There are different schools of thought on when to reset your asset allocation, but according to Tony, you should consider rebalancing at a predetermined time each year. This strategy could help prevent impulsive investing decisions and keep your long-term goals on track.
Turbulence and temptation
Daniel Kahneman, one of the fathers of behavioral finance, has noted that investors will go to great lengths to avoid losses in their portfolio. This behavior, known as “loss aversion,” is especially apparent during volatile times, Tony says. “When the markets are volatile—as they were back in January and more recently following the “Brexit” vote—investors are tempted to sell their portfolios,” he says. The problem, of course, is twofold—exiting at the wrong time and possibly re-entering the market after it has already run up.
There’s an investing adage investors should heed: “It’s not about timing the market—but time in the market.” And as the data above illustrates, missing out on just a few days could lead to dramatically different outcomes. Consider the cautionary tale from the last bear market. After the financial crisis of 2008 for example, many investors panicked and sold. For the next four years, well into a robust recovery, investors continued to pull more money from U.S. stock funds than they put in, only reversing the trend in 2013, according to Morningstar.
Reasons to rebalance
For investors concerned that periods of volatility may have thrown their portfolios off track, Tony has one piece of advice: Wait. Then, refocus on the bigger picture.
Two scenarios might reasonably spur you to rebalance your portfolio. The first: a change in priorities or capacity for risk. Over time, certain life events (like a divorce or illness) or new goals (retiring earlier or later than planned) might cause you to rethink your allocation or reconsider certain asset classes.
But the second and more common scenario is when markets change your asset allocation either through portfolio appreciation or depreciation. For example, suppose you had a 5% allocation to emerging-market stocks in the beginning of 2012, a year in which they turned out to be the best-performing asset class. Based on your rebalancing discipline, you would have trimmed your emerging-markets exposure at the end of the year because your allocation would have grown substantially. And that reduction would have helped in 2013—as the asset class underperformed, going on to rank toward the bottom that year.
In either case, Tony cautions against the desire to make a quick “fix.” Developing a well-diversified portfolio, sticking to your long-term plan and revisiting it periodically, is the most prudent approach.
An annual check-up
If your portfolio isn’t rebalanced automatically or according to a different schedule by your Financial Consultant, the traditional annual portfolio checkup may be your best option, Tony says.
Tony also maintains that, for self-directed investors, reevaluating your holdings on an annual basis offers certain benefits.
First and foremost, it instills investing discipline and could protect you from making emotional investment decisions, he says. Rebalancing can also be costly, so you may want to consider the trade commissions or tax implications you could incur. A disciplined systematic approach—like sitting down with your portfolio once a year—is a good habit that supports your overall financial “hygiene.”
Also, by making a formal assessment once each year, you can refine and prioritize your goals and incorporate those goals into a well-considered financial plan.
When should you do that annual rebalancing? It will vary from investor to investor. But according to Tony, the end of the year is often a good time, when you may want to consider your overall tax picture.
What you can do next
If it’s been a while since you’ve revisited your asset allocation plan, consider talking to a professional to make sure it’s still in line with your long-term goals and risk tolerance.