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Rebalancing Portfolios in a Bear Market

Wells Fargo Investment Institute - April 9, 2020

by Asset Allocation Strategy Team

Key takeaways

  • Large market moves, as we’ve experienced recently, can significantly alter a portfolio’s risk/reward profile and impact how quickly a portfolio may recover from a drawdown. We believe now is a good time for investors to consider reviewing their portfolios for opportunities to rebalance.
  • Rebalancing a portfolio to strategic asset allocation targets is an important component of an investment strategy that can help investors achieve their long-term goals.

What it may mean for investors

  • The need for investors to rebalance portfolios may increase as they approach their investment goals or time horizon. Investors also are encouraged to revisit investment goals during a portfolio checkup to determine whether their investment objectives, time horizon, and risk tolerance have changed.

Buy low and sell high is a strategy that many investors strive to follow. But following this strategy can be challenging in volatile markets, when many asset prices—particularly stocks—are reacting to headlines related to the coronavirus pandemic. A change in economic conditions or large market moves, upward or downward, can significantly alter a portfolio’s risk/reward profile. That’s why we believe now is a good time for investors to consider reviewing the positioning of their portfolios. Rebalancing—taking profits and reallocating into assets that have underperformed—is an important component of an investment strategy that can help investors achieve their long-term goals.1

Chart 1 illustrates the potential effect that rebalancing would have had on a hypothetical 60% stocks/40% bonds portfolio during full market cycles. In view of the significant sell off, it demonstrates why now may be a good time to consider rebalancing, especially if this has not been done recently.

Prior to the start of the current bear market, stocks had experienced a record-long bull market. Without rebalancing since March 2009—the start of the bull market—a 60% stocks/40% bonds portfolio would have drifted to be 84% stocks/16% bonds by February 19, 2020. 

This overexposure to equities drastically changed the risk profile of the intended allocation, leaving the portfolio even more at risk for the sharp downturn. This portfolio that was allowed to drift has since started to drift toward bonds, ending March with an 81% stocks/19% bonds mix. Based on our analysis, using a disciplined rebalancing approach, the hypothetical portfolio is able to achieve a return similar to the portfolio that was allowed to drift, but the volatility of the rebalanced portfolio is significantly lower over this time period, which includes both a bull and part of a bear market.2

Chart 1. Investors should consider rebalancing portfolios to help manage risk

Chart 1. Investors should consider rebalancing portfolios to help manage risk

Sources: Morningstar Direct, Wells Fargo Investment Institute; March 31, 2020. In this example, stocks are represented by the S&P 500 Index, and bonds are represented by the Bloomberg Barclays U.S. Aggregate Bond Index. Current market cycle illustrations are for the period March 9, 2009 to March 31, 2020 with starting allocation of 60% stocks and 40% bonds on March 9, 2009. Previous market cycle illustrations are for the period October 9, 2002 to March 9, 2009 with starting allocation of 60% stocks and 40% bonds on October 9, 2007. Index return information is provided for illustrative purposes only. Index returns do not represent investment performance or the results of actual trading. Index returns reflect general market results, assume the reinvestment of dividends and other distributions, and generally do not reflect deduction for fees, expenses, or taxes applicable to an actual investment. The S&P 500 Index is a market capitalization index composed of 500 stocks generally considered representative of the U.S. stock market. The Bloomberg Barclays U.S. Aggregate Bond Index is a broad-based index that measures the investment grade, U.S. dollar-denominated, fixed-rate taxable bond market. An index is unmanaged and not available for direct investment. Hypothetical and past performance does not guarantee future results.

A similar pattern is evident looking at the previous market cycle (bottom of Chart 1) including the bull market from October 2002 through October 2007 and the bear market from October 2007 through March 2009. During that market cycle, which included part of the "lost decade" for U.S. stocks, the hypothetical rebalanced portfolio had a higher return and lower volatility than the non-rebalanced portfolio. At the end of the bull market, the portfolio allowed to drift had an over-allocation to equities of 72% vs. the intended 60%. By the time the bear ended, the portfolio was over-allocated to bonds. An over-allocation to equities can leave a portfolio more at risk than may be intended during a downturn, while an over-allocation to bonds at the end of the bear market can reduce return potential, which leaves the portfolio more at risk for a longer recovery time.

We recognize that rebalancing a portfolio can be an emotional undertaking for some investors, but rebalancing during a bear market is crucial as it allows an investor to purchase stocks for lower prices as prices fall. Allowing the portfolio to drift during a bear market is likely to result in a higher allocation to fixed income than intended, as portfolio allocations drift from strategic targets and an investor's desired risk level. This could impact the time it takes for a portfolio to recover once the bear market is over.

For example, a hypothetical 60% stocks/40% bonds portfolio rebalancing quarterly recovered two months earlier than a portfolio allowed to drift after the previous bear market (10/9/2007–3/9/3009). Additionally a more balanced, diversified allocation like Moderate Growth & Income, rebalanced quarterly, recovered seven months sooner than a quarterly rebalanced 60% stocks/40% bonds allocation and five months ahead of its non-rebalanced counterpart.

Table 1. Recovering from bear markets

Table 1. Recovering from bear markets

Sources: Morningstar Direct, Wells Fargo Investment Institute; March 31, 2020. Performance results for the Moderate Growth and Income Four Asset Group portfolio without private capital (PC); and 60% S&P 500 Total Return Index, 40% Bloomberg Barclays Aggregate Index portfolios are hypothetical and are presented for illustrative purposes only. Performance results for the Four Asset Group without private capital and the 60/40 portfolios are hypothetical and for illustrative purposes only. Hypothetical results do not represent actual trading. An index is unmanaged and not available for direct investment. Hypothetical and past performance does not guarantee future results. Please see the end of the report for the risks associated with the representative asset classes and the definitions of the indices. Index returns reflect general market results, assume the reinvestment of dividends and other distributions, and generally do not reflect deduction for fees, expenses, or taxes applicable to an actual investment. Moderate Growth and Income Four Asset Group model portfolio without private capital: 3% Bloomberg Barclays U.S. Treasury Bills 1–3 Month Index , 16% Bloomberg Barclays U.S. Aggregate Bond Index (5–7 Year), 6% Bloomberg Barclays U.S. Aggregate Bond Index (10+ Year), 6% Bloomberg Barclays U.S. Corporate High Yield Bond Index, 5% JPM EMBI Global Index, 20% S&P 500 Index, 10% Russell Mid Cap Index, 8% Russell 2000 Index, 6% MSCI EAFE Index, 5% MSCI Emerging Markets Index, 3% HFRI Relative Value Index, 6% HFRI Macro Index, 4% HFRI Event Driven Index, 2% HFRI Equity Hedge Index.

Is it time for a portfolio checkup?

Once an asset allocation has been selected, we believe that a “set it and forget it” mindset is unlikely to work effectively in today’s markets, especially as volatility ramps up. To help keep a portfolio on track, we believe that investors should consult their investment professional and review its positioning, at least annually, to determine whether it needs any adjustments and/or rebalancing.

During a bear market, we believe investors should focus on reallocating to those asset classes that tend to sell off the most during a drawdown. In our view, by rebalancing in this manner and bringing a portfolio’s risk profile back to the desired level, investors are more likely to stick to their plans, endure market downturns, and be better positioned to work toward their long-term goals. Rebalancing does involve realizing gains, which could have tax consequences. Investors should consult a tax professional and an investment professional to develop a tax and rebalancing strategy that works for their unique circumstances. Investors also are encouraged to revisit short-term and long-term goals during a portfolio checkup to determine whether investment objectives, time horizon, and risk tolerance may be evolving.

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1 Keep in mind, liquidating holdings could have tax consequences. Wells Fargo Investment Institute and its affiliates are not tax or legal advisors.

2 Volatility is measured using standard deviation of monthly returns, which is a statistic that reflects the degree of risk surrounding the outcome of an investment decision. The higher the standard deviation, the greater the risk.