Rebalancing Your Portfolio in a Falling Market
Fight or Flight
There is an almond-shaped part of our brains called the amygdala. This part of our brain processes environmental stimuli and helps identify things we would perceive as threatening, initiating our “fight-or-flight” response. This response is deeply ingrained in our DNA. Prehistoric men would have experienced this if a saber-toothed tiger was spotted nearby. The same response that kept our predecessors alive is what sends signals to the muscles in your arm and hand to remove it after accidentally touching a hot stove.
Unfortunately, this fight-or-flight response can prove hazardous in our investing. You turn on CNBC and see the headline “Markets in Turmoil.”
Some scientists believe that just by seeing the color red can influence our emotions. The color red is often associated with danger, and to use caution. You can see references to this in our daily lives. Stop signs, wrong-way signs, red lights, ambulances. Is it so far-fetched to believe the intentions of the picture above is to trigger an emotional response? When we see red on our screens or our investment statements, this can also trigger our flight-or-fight response. We are experiencing a sort of pain. Our brains are hardwired to look for a way out. Remove your hand from the stove? Get rid of the part of your portfolio, causing pain? Not so fast.
Example of Rebalancing Your Portfolio in a Falling Market
Say you have a $500,000 portfolio. You typically rebalance the portfolio to keep your $500,000 in-line with a certain allocation. Let’s say you wanted to have an investment account that was 50% weighted to US stocks (SPY), and 50% weighted to US bonds (AGG). On January 1, 2020, you have exactly $250,000 in both investments. Three months later, you look at your first quarter statement. Your position in SPY is down about 20% and has gone down in value by $50,000. And your position in AGG has held steady, earning 3%, up about $7,500. Your investment in US stocks now only represents about 44% of your portfolio, and US bonds about 56%. So, your portfolio has drifted away from its targeted 50-50 ratio.
Techniques for Rebalancing Your Portfolio
There are many ways to go about rebalancing your portfolio. One of the simplest forms of doing so is to have a predetermined interval, at which point you will rebalance. You can do this monthly, quarterly, semi-annually, or annually. When the date arrives, you’ll go into your portfolio and make the necessary adjustments, regardless of what you think or feel about the markets.
Another technique is to use rebalancing bands. For example, if your 50% weight in stocks rises or falls by more than 5%, you would either buy shares or sell shares, using the 50% weight in bonds to either fund your purchase of stocks or if selling stocks, moving the proceeds of the sale into your bond investments. This technique can be a bit more time-consuming than using a predetermined schedule for rebalancing but can prove useful when the market makes sharp moves in either direction.
Rebalancing Your Portfolio is a Powerful Tool
Regardless of the rebalancing method you choose to use, this is a technique that has historically proven a powerful tool. For example, let’s stick with our 50-50 portfolio. From November 2007 to February 2009, this portfolio would have been drawn down by 23%. It took until October 2010 to get back to the November 2007 value. However, if we used a 5% rebalancing band, it reached its recovery date by April 2010, six months earlier!
Ultimately, it can still prove to be difficult on an emotional level to rebalance, even though we can make an argument that the math says we should. You turn on the tv, see the Markets in Turmoil sign, log in to your investment account, and see red arrows and minus signs. Your amygdala is working, drawing upon your past experiences to send signals throughout your brain. The fight-or-flight response kicks in. Should you sell the investments causing pain, or should you rebalance, buying more of the investments which are flashing red?
If you’re wondering whether rebalancing at this time is right for you, we can help. Give us a call at 913-393-1000 or schedule the complimentary consultation below. We can set up a call or virtual meeting to address your questions.
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The views expressed represent the opinion of Modern Wealth Management an SEC Registered Investment Advisor. Information provided is for illustrative purposes only and does not constitute investment, tax, or legal advice. Modern Wealth Management does not accept any liability for the use of the information discussed. Consult with a qualified financial, legal, or tax professional prior to taking any action.