The Power of Rebalancing During a Volatile Market

There’s no doubt that the past decade has seen some volatile stock markets.  And some people (understandably) find that frightening.

But if you create a diversified account of stocks and bonds (or stock and bond indexes) and if you rebalance your account by ensuring that you keep your account’s allocation relatively consistent, then you can make a small fortune during volatile markets.

But to do so takes courage. 

When stocks fall, the media exploits investors’ fears, so for anyone following the news, a falling market could be a terrifying time.  But it shouldn’t be.  A lower stock market is a safer long term investment than a high stock market.  If you’re adding money to the markets, you should feel relief when the markets fall, not fear.

The nice thing about having a blog is that I can make my investment moves public, and then refer back to them.

Let’s look at the previous year or so.

In May/June 2010, the stock markets were lower than they are today.  If you didn’t know that, then you’ve been influenced by the media.  It’s true.  Despite the recent stock market drop, the markets are a lot higher today than they were in June, 2010.

I have an allocation of bonds that’s close to my age:  roughly 40%.

When the markets fell in 2010, my allocation of bonds was higher than 40%, so I had to make an adjustment at the beginning of June.

This is what I wrote from a 2010 post:

Selling off more than $120,000 in bonds, (in June) I bought decent sized positions in:

Here are the prices of those holdings today (August 27, 2011)

  • Coca Cola:  $68.50 (up 41% including dividends)
  • Johnson & Johnson:  $64.28 (up 16% including dividends)
  • XDV.To:  $20  (up 12% including dividends)
  • Microsoft:  $25.25  (up 8% including dividends)

I did eventually sell all of those stocks to buy indexes, but for stock pickers, there might be an additional lesson in this.

When you feel that a stock is a particularly great deal, don’t be afraid to put a large amount of money in it.  Sure, I sold bonds and put $120,000 in the stock market, but more than half of that money went into Coca Cola.

Of the above stocks, I was most convinced that Coca Cola was the best bet.  So I bought $65,000 of Coca Cola stock when I rebalanced my account.  You can read about my purchase here, while seeing what my rationale was behind it.

My second biggest purchase was Johnson & Johnson, at $57 per share…which cost me roughly $35,000.

Assuming that I still owned all of the above holdings today, the gain from rebalancing that $120,000 in June, 2010 would amount to $33,000—and that’s after the recent stock market drop.  However you slice it, $33,000 isn’t chump change.

During volatile markets, rebalancing between stocks and bonds adds some serious juice to your investment returns.

On August 20th, 2011 I rebalanced my account again, selling $50,000 of bonds and buying the U.S. stock index.  It’s silly to think short term, but that $50,000 is now worth $52,400.

Do I want the markets to keep rising?  Nope.

I want them to fall.

And one of my online buddies, Value Indexer, explains why—better than I could.

Keep an eye on your investment allocation, and adjust the holdings (to maintain your target allocation) during big market moves.

If the markets bounce up and down like a kid on a pogo stick for the next decade, you’ll make loads of money from the volatility while the world’s emotional investors lament about the fact that you can’t make money in stocks anymore.

When you hear that, just turn away and smile.

Andrew Hallam

I’m a financial columnist for Canada’s national paper, The Globe and Mail, as well as for AssetBuilder, a financial service firm based in Texas. I’m also the author of Millionaire Teacher: The Nine Rules of Wealth You Should Have Learned in School and Millionaire Expat: How To Build Wealth Living Overseas. My mission is to educate, motivate and inspire people on basic retirement planning and best practices for investing, using evidence-based strategies. I'm happy to comment on your questions.

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19 Responses

  1. Thanks for the mention Andrew! There are so many upsides to falling markets, especially if you rebalance well, that it almost seems like there's some evil marketing plot to make ordinary investors believe otherwise 🙂

    • Hey Value Indexer,

      You're absolutely right. During bull markets, of course, rebalancing would create a small drag on returns. But during fearful, volatile markets, rebalancing is like taking candy from babies. It just takes guts to do it.

  2. So, Andrew, how often do you rebalance your portfolio? Do you do base on periodic time intervals? Or when you think the markets has overcorrected? Are you worried about the taxes that selling generates?

    • Hey Biz,

      Great to hear from you. I rebalance when my allocation is distorted, based on the desired allocation I set for it. But to be honest, I don't have a hard and fast rule. If the markets fall 10%, I don't usually bother. I just buy the lagging index with any fresh money that I may be adding to my account. But if we get a 15% or 20% drop in the markets (or a 15% to 20% rise) I take it a bit more seriously. I don't want to mess around with small numbers. If I'm going to rebalance, I want to make it worthwhile.

      Your question about taxes is an excellent one. In a tax deferred account (as you know) there are no consequences to rebalancing. In a taxable account, there are.

      My account doesn't trigger capital gains taxes at all (Residents of Singapore—unless their Americans—don't have to pay capital gains taxes)

      But I would still have rebalanced a taxable account in the U.S. or Canada. Assuming a gain of $33,000 in just 14 months, I can look at two realities:

      1. If I didn't rebalance, I would not have made that gain

      2. Because I rebalanced, I would have to pay tax on that $33,000

      However, if I didn't rebalance, I wouldn't have made that $33,000 in the first place.

      So in this case, it would have been better to rebalance, make money, and pay tax on that money, versus not making money, and not paying tax.

      • Stanton Y says:

        Hi Mr. Hallam,

        Thanks for another great post!

        Would you recommend young investors to open a tax deferred account like a Roth IRA? I have a regular taxable account at the moment, but like you say, with a tax-deferred account, there are no consequences to rebalancing.

        • Hey Stanton,

          Yeah, filling up the room in your IRA is the first thing you need to do. After you've made your maximum contribution for the year, you can invest outside your IRA.

  3. Great stuff Andrew.

    I can't hear stuff like this enough:

    "When you feel that a stock is a particularly great deal, don’t be afraid to put a large amount of money in it."

    "…rebalancing between stocks and bonds adds some serious juice to your investment returns."

    "Do I want the markets to keep rising? Nope. I want them to fall."

    Keep up the great stuff!


  4. The Dividend Ninja says:

    Andrew what a great post!

    You've given some concrete examples of how your strategy has worked big-time! I think this one line sums it up nicely:

    "During volatile markets, rebalancing between stocks and bonds adds some serious juice to your investment returns."

    There is one catch though, and I'm certian we've already been through a few periods where both bond and stock asset classes would correlate. In other words stock and bond prices move higher and lower together. I see an advantage here to holding dividend stocks for the dividend income, over equity ETFs. Do you think that is even a significant factor?


  5. Thanks Ninja,

    And you're absolutely right. There are times when stocks and bonds to correlate. But it's funny, when you put a correlating stock and bond chart together (if they both drop).

    But when they do correlate (at least, based on what we know of history) bonds don't fall as far as stocks. So I would sell bonds that have fallen 10% to buy equities that have fallen 30%.

    And Hey! Thanks for putting me on your Top 10 Personal Finance Blogs. To say that I'm honored doesn't cut it! A friend of mine emailed me to tell me about it. Thanks!!! He, also, is a big fan of yours!

  6. A major reason I like falling markets is due to share repurchases and dividend reinvestment. Many American businesses do share repurchases, and whether they're in the best interests of shareholders or not compared to dividends is endlessly debatable (and most side with dividends), businesses are going to keep doing them regardless. That said, I'd certainly rather my holdings were repurchasing shares in a low valuation market than a high valuation market, since they get a better rate of return on that capital. The same thing goes for reinvesting dividends. When more money is being put into the market (whether it's my fresh capital, my dividends, or capital from the businesses I own to buyback shares), a down market is preferable. I want valuations to preferably be low, or at least moderate, rather than high.

    One thing I did last month was write a program to calculate how different indexed portfolios would have performed over the last 35 years (different allocations of rebalanced US stocks and bonds). I thought about posting my findings, but instead figured I'd do more research, and possibly include it in with an e-book I've been considering publishing. Or if I never write the book, I'll just post it eventually. One way of modifying the automation of rebalancing without subjective market timing is to change the allocation based on objective quantitative effects, like average P/E multiples of the market, or interest rates, or Buffett's index of comparing GNP to the total stock market valuation. The risk, of course, is that if one finds something specific that worked well over the last 35 years, it may or may not be what will work for the next 35 years, unless one can accurately construct an argument as to why that strategy worked the way it did and should continue to do so.

  7. Hey Dividend Monk!

    Your rationale for wanting a falling market is a great one! Here's a question/calculation/scenario you would love:

    Should a 20 year old investor prefer scenario A or B?

    A: The markets are paying a 3% dividend. Then the markets fall by half, and remain at that level for 40 years, while the investor reinvests dividends

    B: The markets are paying a 3% dividend. Then the markets double, and stay there for 40 years, while the investor reinvests dividends.

    Scenario A gives a 6% dividend yield (like the markets averaged from 1965 to 1982) while scenario B gives the market a 1.5% yield.

    And of course, over time, dividends increase in both scenario A and B.

    Most young investors would incorrectly choose option B (hoping that the markets double). Guys like you, would know better. Scenario A would be more profitable over time.

    • Yup, A's the better choice. That's certainly a good trick question for newer investors.

      And that's exactly the mechanism behind how a company like Altria (MO) became one of the best performing stocks of the second half of the 20th century: Solid business growth coupled with a valuation that was low for a very, very long time, and large dividends. Investors that patiently held those shares for decades, and reinvested dividends, made a ludicrous annual rate of return.

      • Hey Matt,

        These are things that people really should learn in school, don't you think?

        You're so right about Altria…a total sleeper. The same thing applies, as you know, to fast growing economies as well.

        England has been so outstripped by the U.S. during the past 100 years, as far as GDP growth is concerned. But its stock market has matched the U.S. market, with all dividends reinvested.

        Those who think they'll make more money in Emerging Markets will find something similar. David Swensen found that from 1985 to 2006, developed market returns, with reinvested dividends, beat emerging market returns (1985 was the earliest time period that we have records for Emerging Markets). That's something else people should learn in school.

  8. Robber Baron says:

    Some interesting reports floating now about how bond market ETFs may be topping out.

    That as most have multiple expiry dates (when the invested bonds expire they just buy new ones) the inevitable rising interest rates (projected to start from spring 2012 to "six months after the Euro crisis is addressed" to six years from now!) will cause valuation of the ETFs to fall.

    Do you buy actual bonds, or bond funds/ETFs, and what's your thought on this? Would you "anticipate" if your were approaching a magic number for re-balancing?

  9. Matt says:

    I've just read Millionaire teacher and I am starting to invest. One question: As a Canadian with 25% of my portfolio in a US stock index fund, would their be any benefit to using a US stock index fund in USD over the US stock index in Canadian dollars?

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