Why rebalancing can help when markets decline

Markets are quick to react to change and current events causing them to rise and fall frequently and sometimes substantially. This summer’s double digit decline in U.S. stocks is just the latest example. Such swift declines can add to a sense of chaos and make investors uneasy. As chaotic as markets can be, if we are to get any meaningful return on our investments, we have to be able to adapt to the chaos by taking the prudent action to rebalance accounts.

Rebalancing provides a sound methodology for handling the chaos of the financial markets and can make our investment experience a bit steadier.

The term “rebalancing” can be puzzling because financial markets often seem anything but in balance. It doesn’t make the world safe, politicians smart, the tax code simple, or investment returns steady. Rebalancing provides a sound methodology for handling the chaos of the financial markets and can make our investment experience a bit steadier.

There are many angles and nuances to rebalancing but we will focus on the two benefits we see most prominently: controlling risk and taking emotion out of decision-making.

What is rebalancing?

Rebalancing is the process of buying and selling within a portfolio to keep a portfolio’s structure in line with its targeted mix of investments. Staying aligned with the target is important because the target is established based on client goals. Being too conservative or too aggressive with portfolio structure can be costly and potentially cause the portfolio to fall short of its goals.

As the chart below shows, being too aggressive can result in significant losses but being too conservative can result in little growth and the loss of purchasing power due to inflation.

Rebalancing can help keep us from panicking when markets are bad and help prevent greed from overtaking us when markets are good.

With the recent decline fresh in our memory, here is a simple example of how rebalancing can help when markets drop.

Assume that in light of one’s goal, we determine that a portfolio should hold half its assets in “A”, a fairly stable investment that has little chance of dropping greatly in value but also with no real opportunity to grow substantially. Cash, CD’s, and good bonds would all be the underlying assets in A.

The other half, “B”, is determined to hold assets in something riskier in the short term, but has good long term growth prospects. Diversified stocks fit this description.

To make the math a little easier to follow, we will use $200,000 in a 50/50 split between A and B with $100,000 in each. A earns 4% while B loses 20%. The total is $184,000 (A=$104,000 and B=$80,000), down 8%.

The portfolio now sports a 57% A to 43% B mix. It is overexposed to the risks and potential return of A and underexposed to the risks and potential return of B. To rebalance, $12,000 of A is sold to buy $12,000 of B, leaving $92,000 in each. The portfolio is back to 50/50.

The investor has lost $16,000 and just bought $12,000 more of the very thing that caused the loss so at this point, how rebalancing provides risk control and a defense against emotional tactical decision-making is not obvious! We will get into the emotional discipline in a moment but first let’s do more math.

Rebalancing and risk control

Without rebalancing and assuming A again rises 4%, A would be worth $108,160 and B would have had to increase to $91,840 or 14.8% for the portfolio to reach the original $200,000.

Because we sold $12,000 of A to rebalance another 4% will only make it worth $95,680. Therefore B must rise to $104,320 to put the portfolio back to $200,000. But, because we bought $12,000 more of B, it only needs to rise 13.39% ($104,320-92,000/92,000).

B will rise 13.39% before it rises 14.8%. By rebalancing, the portfolio recovers faster. In fact, at a rise of 13.39%, the actual price of B would still be off by 9.29% from its starting point when we bought the original $100,000. The portfolio is whole yet the offending holding is barely halfway recovered.

One thing investors crave when experiencing a decline in portfolio value is to erase the loss as fast as possible. Rebalancing will help do that. Despite this, many are anxious about rebalancing because the other thing investors want after a decline in portfolio value is to not lose any more value.

Indeed, if B drops more, rebalancing adds to the losses.

In our example we assumed B recovers after dropping 20%. But what if B drops to 40% of its original price. If we had not rebalanced, A would be worth $108,160 but B would have been worth $60,000 for a total of $168,160, down 15.93%.

So, how much more did rebalancing cost when B had lost just 20%? Mathematically, B dropped another 25% (from $80,000 to $60,000) after its initial 20% drop to get to minus 40% in total. That $92,000 post-rebalancing became $69,000 and A’s portion became $95,680 for a total of $164,680. The rebalancing only reduced total return a mere additional 1.73% to -17.66%.

The fear of a loss could be worse than the actual loss, which leads to some dangerous psychology rebalancing can help us minimize.

Rebalancing can take some emotion out of decision-making

In our scenario, we made no mention of the amount of time between transactions or what happened during the time periods. This could have occurred over an hour, a year, or a decade. Between transactions there could have been a highly contested election, a natural disaster, or a terrorist attack. The tax code could have been completely overhauled. You could have had a major health crisis or lost a spouse. You could have been laid off or promoted. B could have gone far lower or higher or just muddled around. None of that nor anything else changes the math.

The math is simple. To stay on track, you rebalance and doing so when markets decline accelerates your recovery no matter if the recovery is quick or not.

A successful investment experience requires making decisions about an ongoing series of life events in a chaotic world – in real time.

Whether the rebalancing transaction occurs at the bottom, early, or late makes no difference to the math above, but psychologically it presents some challenges. Few will want to “throw good money after bad” or “catch a falling knife” as pundits discuss “head fakes,” “dead cat bounces,” “sucker’s rallies,” short covering, or similar things. If you recall the 2008 financial crisis, these phrases may sound familiar.

When the market is down, usually both anxiety and the fear mongering that thrives on it increases. It is easy to forget that stocks have risen more than they have fallen and that advances have been far stronger than the declines.

Rebalancing after strong markets has benefits too. To use a casino metaphor, it allows one to take some chips off the table and keep some profits. It makes it less likely one will get caught up in the euphoria and “let it ride” or engage in other undisciplined behavior like making bets on highly speculative endeavors with “house money.”

Committing to a sound rebalancing discipline encourages decisions and behaviors which make goal achievement more likely. One’s portfolio largely maintains the exposure to the appropriate risks needed for those goals over the long term while buying a little at relatively low prices and selling a little at relatively high prices.

Buy low, sell high. Rebalancing is a manner of executing that idea without requiring an accurate market prediction. Having a rebalancing discipline can help address some of the emotional aspects of managing a portfolio because one may be less inclined to get swept up in times of hype or dragged down in times of despair.

Buy low, sell high. Rebalancing is a manner of executing that idea without requiring an accurate market prediction.

The core concept is pretty simple but we’ve only isolated one sequence here and are leaving out a great deal more which could be said about rebalancing. There are many nuances and issues to navigate such as when exactly to rebalance, how to manage the tax impact of rebalancing transactions, and how rebalancing between different parts of the world stock markets differs from rebalancing between stocks and more stable holdings, to name but a few. We will cover those in time.

Keep calm and carry on

When conditions are particularly chaotic, we crave control. We cannot control when, or even whether, we are rewarded for risk taking but we can control the types and levels of risks we bear and how we behave when those risks reward or punish us.

In the article, “Rebalancing and Returns,” researcher Marlena Lee aptly said, “The primary motivation for rebalancing should not be the pursuit of higher returns, as returns are determined through the asset allocation, not through rebalancing… Rebalancing decisions should be driven by the need to maintain an allocation with a risk and return profile appropriate for each investor.”

Neither good times nor bad times last forever. Whichever comes next, there will be yet another “next” after that. Having an investment portfolio that is designed to support your goals and is implemented with diversification, discipline, and patience remains the best strategy.

Contact Us

If you have any questions or would like to discuss this further, please give us a call or send us a note.

If you are not a client and you wish to receive emails notifications of new posts – no more than monthly – fill out the subscription information in the sidebar to the right.

 Contact Us

Moisand Fitzgerald Tamayo, LLC is an Orlando, Tampa and Melbourne, Florida based fee-only financial planner serving central Florida and clients across the country. Moisand Fitzgerald Tamayo, LLC specializes in providing objective financial planning, retirement planning, and investment management to help clients build, manage, grow, and protect their assets through all phases of one’s life and the many transitions in between. If you have any questions or would like to discuss anything further, please give us a call or send us a note. If you are not a client and wish to receive emails notifying you of new posts – no more than once per month – fill out the subscription information in the sidebar to the right. For more frequent updates, follow us on FacebookLinkedIn, or Twitter.  

Important Additional Information & Disclosures

Please remember that past performance may not be indicative of future results.  Different types of investments involve varying degrees of risk, and there can be no assurance that the future performance of any specific investment, investment strategy, or product (including the investments and/or investment strategies recommended or undertaken by Moisand Fitzgerald Tamayo, LLC-“MFT”), or any non-investment related content, made reference to directly or indirectly in this blog will be profitable, equal any corresponding indicated historical performance level(s), be suitable for your portfolio or individual situation, or prove successful. 

Due to various factors, including changing market conditions and/or applicable laws, the content may no longer be reflective of current opinions or positions.  Moreover, you should not assume that any discussion or information contained in this blog serves as the receipt of, or as a substitute for, personalized investment advice from MFT. 

Please remember that if you are a MFT client, it remains your responsibility to advise MFT, in writing, if there are any changes in your personal/financial situation or investment objectives for the purpose of reviewing/evaluating/revising our previous recommendations and/or services, or if you would like to impose, add, or to modify any reasonable restrictions to our investment advisory services. To the extent that a reader has any questions regarding the applicability of any specific issue discussed above to his/her individual situation, he/she is encouraged to consult with the professional advisor of his/her choosing. MFT is neither a law firm nor a certified public accounting firm and no portion of the blog content should be construed as legal or accounting advice. Tax advice is given only to clients and only when agreed to by MFT. A copy of the MFT’s current written disclosure Brochure discussing our advisory services and fees is available for review upon request.

Please Note: MFT does not make any representations or warranties as to the accuracy, timeliness, suitability, completeness, or relevance of any information prepared by any unaffiliated third party, whether linked to MFT’s web site or blog or incorporated herein, and takes no responsibility for any such content. All such information is provided solely for convenience purposes only and all users thereof should be guided accordingly.

Please Note: Limitations:  While MFT does NOT pay for recognition, awards, or publicity, neither rankings and/or recognition by unaffiliated rating services, publications, or other organizations, nor the achievement of any designation or certification, should be construed by a client or prospective client as a guarantee that he/she will experience a certain level of results if MFT is engaged, or continues to be engaged, to provide investment advisory services. Rankings published by magazines, and others, generally base their selections exclusively on information prepared and/or submitted by the recognized adviser. Rankings are generally limited to participating advisers. No ranking or recognition should be construed as a current or past endorsement of MFT by any of its clients.  ANY QUESTIONS: MFT’s Chief Compliance Officer remains available to address any questions regarding rankings and/or recognitions, including providing the criteria used for any reflected ranking.

Historical performance results for investment indices, benchmarks, and/or categories have been provided for general informational/comparison purposes only, and generally do not reflect the deduction of transaction and/or custodial charges, the deduction of an investment management fee, nor the impact of taxes, the incurrence of which would have the effect of decreasing historical performance results.  It should not be assumed that your MFT account holdings correspond directly to any comparative indices or categories. Please Also Note: (1) performance results do not reflect the impact of taxes; (2) comparative benchmarks/indices may be more or less volatile than your MFT accounts; and, (3) a description of each comparative benchmark/index is available upon request.


About Dan Moisand

Dan Moisand is a fee-only financial advisor with Moisand Fitzgerald Tamayo, LLC. He is a regular contributor for multiple outlets, including Florida Today, MarketWatch, and The Wall Street Journal. His writing and financial advice have also been featured in Financial Planning, Investment Advisor, Wealth Manager/Advising Boomers, Forbes, Smart Money, and The New York Times, among other publications. He is the only two-time winner of the Journal of Financial Planning’s “Call for Papers” competition and has been named a top financial planner and advisor by multiple publications. Investment News named Dan one of the “twenty most influential men and women” in the history of financial planning. He currently serves on the Board of Directors for the CFP (Certified Financial Planner) Board.


As a Sanctuary From The Noise®, we only post information we believe timely and important to the long term financial success of our clients. Follow us to receive emails - no more than once a month - about new posts.

We keep your information private and make stopping our emails as easy as starting them.

Something went wrong. Please check your entries and try again.