Portfolio Rebalancing the Smart Way

Portfolio Management
July 16, 2023

The concept of quarterly or annual portfolio rebalancing sounds appealing. It works like this. If your current asset allocation is 60% equities and 40% US Treasuries, you're supposed to check the allocation at certain fixed periods and then rebalance the portfolio to retain the 60/40 mix as the market values of the assets fluctuate.

The theory behind this is that it forces you to sell the assets in your portfolio that have appreciated the most, and are potentially over-valued, and use those funds to buy more of the assets that didn’t perform as well. It's intended to prevent you from becoming too concentrated in overvalued assets. In theory, it seems like a sound strategy. We’ll discuss why we use a modified re-balancing strategy later.

First, let's walk through the way it's supposed to work. The table below shows the transactions. You start with a 60/40 split with the 60% being equities. At the end of the year, the equities have increased 12% while the bonds are flat. In order to maintain the 60/40 split, you have to sell $2,880 worth of stock and use those funds to buy bonds. This will maintain your 60/40 allocation split.

In most of the rebalancing strategies we've seen, the current valuation of the assets is ignored. We think that’s where the flaw lies. Our re-balancing strategy revolves around the current valuation of the assets in the portfolio compared both to their historical norms and each other.

Here’s the plain vanilla rebalance in action. Let’s assume the market increases 8% a year (it’s long-term historical average) and the 10 year Treasury is stable at 2%. In a straight rebalancing model, each year you’d sell about 3% of your equity portfolio, pay Capital gains tax and invest what’s left over in 10 year Treasuries at a 2% yield. In our opinion, that’s suboptimal.

Here's an example of a valuation based rebalance. Let's use the same 2 assets, 10 year treasuries and the S&P 500. For the record, our portfolio is individual stocks not indices, but the principle is exactly the same. Let's say that our target allocation is 60% equities and 40% bonds. We would have that blend in our portfolio if BOTH assets were fairly valued. For example, from 1990 to the first half of 2018, the median 10 yr Treasury yield was 4.55%. If we use 1980 as the start date, the median yield was 5.67%.

Since the end of the summer of 2011 until the middle of 2022, there's been only 4 days where the 10 yr closed above 3%. The Fed had been suppressing rates since the crisis, and that's caused the 10 yr to be, in our opinion, wildly overvalued. During that 11 year timeframe, the yield was under 2.2% the majority of the time. I can’t think of a circumstance where we’d own 10 year Treasuries at a 2% yield pre-tax. That’s 1.2% after tax. My mattress offers a similar yield.

We have different allocation models for different ranges of 10 Year Treasury yields. For example, our assets allocation model might look like this if the yield on the 10 year was between 4% and 4.5%. The left column reflects our model’s opinion on the valuation of the S&P 500. There are many methods of calculating an overvalued or undervalued metric. That’s why we use the term opinion.

This isn't our actual allocation model, but it gives you a sense of our strategy of valuation asset allocation instead of mindless (in our opinion) rebalancing. The top line shows our allocation if our models indicate that the S&P 500 is 50% overvalued compared to Treasuries. If that were the case, we'd have 10% in equities and 90% in Treasuries.

If you look at the last 2 lines in the table, they show our allocation if the models indicate the S&P 500 is 40% or more undervalued compared to Treasuries. In that case, we'd have 90% in equities and 10% in Treasuries.

It's very important to note that break points in a model like this are specific to the investor’s current financial situation and their long-term goals. For example, if you are 60 years old and currently have $50M, and your goal is to have $55M when you're 70, your asset allocation table might not look like the one above. Your minimum allocation to Treasuries might be 85%.