Should you rebalance in a down market?

A strategic approach can help you achieve your long-term goals.

Article published: November 02, 2022

Holding two opposing ideas at once can be difficult, made even more so when those ideas exist in different timeframes. But one of the secrets to helping build your wealth is focusing on your long-term financial plan, while at the same time avoiding making mistakes in the short term.

That’s the smart approach, because short-term decisions can have long-term consequences, and they can be costly. Acting impulsively or emotionally based on short-term market volatility can have a devastating impact on your portfolio and possibly jeopardize your ability to reach your financial goals.

A common short-term mistake that investors make is changing their rebalancing strategy in a down market. This is a tacit form of market timing, and as you’ll discover, it’s something you’ll want to avoid.

The benefits of rebalancing

First though, let’s take a look at the concept behind rebalancing a portfolio.

At Edelman Financial Engines, we construct our client’s portfolios based upon their individual needs and the financial goals they wish to achieve. This involves a strategic allocation of funds across various asset classes and market sectors.

Asset classes and market sectors perform independently – and differently – from each other. Over time, some will rise, and some will fall. This means that a portfolio’s allocation into individual asset classes and market sectors can get out of alignment, some becoming overweighted while others remain underweight.

Those overweighted parts may expose a portfolio to outsized risk, while being underweight in other areas might adversely affect returns.

Rebalancing takes advantage of the normal up and down market cycles by trimming outperforming investments to bring them back in line with the original allocation model, then reinvesting those proceeds into underweighted assets.

Of course, anybody can rebalance a portfolio. There are even robo-advisors and online software that can do it for you. But it’s how you rebalance, the specific methodology you use, that matters.

When should you rebalance a portfolio?

Rebalancing monthly, quarterly or based on any other arbitrary time frame, presents a major problem. In between rebalancing days, your portfolio may become overweighted in some assets, potentially exposing you to increased risk. Conversely, other assets may become underweighted, possibly preventing you from taking advantage of market cycles.

Our approach is to rebalance by percentage, not by the calendar. We periodically review our client’s portfolios for rebalancing opportunities. And when a portfolio drifts outside of its allocation thresholds, we rebalance it to bring it back into alignment with its original allocation model.

So back to the original question, should you rebalance your portfolio in a down market?

A better way to think about portfolio rebalancing

“You should rebalance your portfolio anytime it has deviated or ‘drifted’ enough from your original allocations,” says Claire Mork, director financial planning.

“This process of rebalancing allows our clients to sell assets that have outperformed, then reallocate the proceeds into underperforming assets, essentially seeking to sell high and buy low. And when you’re consistently rebalancing it can allow for risk to be better managed long-term.”

One of the advantages of a rebalancing strategy is that changes can be made to a portfolio when needed. Sometimes that need is relative to market performance, but not always.

For example, in early 2022 both stocks and bonds were down. If you were in a moderate risk portfolio, one that was split evenly between stocks and bonds, your original asset allocations may still have been in alignment, and you wouldn’t need to rebalance.

But in general, if stocks grow more than bonds or cash, over time the stock portion of a portfolio can get out of alignment. By rebalancing, allocations are automatically put back into proper alignment, based upon pre-determined parameters.

“Another advantage of rebalancing,” says Mork, “is that it’s a disciplined approach, which helps eliminate subjectivity and emotions in the decision-making process. And it’s designed to help reduce volatility and investment risk in your portfolio while maintaining your allocation.”

If you have any questions about rebalancing and how it can affect your portfolio, don’t hesitate to reach out to an Edelman Financial Engines planner today. We’re here to help.

Investing strategies, such as asset allocation, diversification or rebalancing, do not ensure or guarantee better performance and cannot eliminate the risk of investment losses. All investments have inherent risks, including loss of principal. There are no guarantees that a portfolio employing these or any other strategy will outperform a portfolio that does not engage in such strategies.

Past performance does not guarantee future results.