Should I rebalance during market crashes?

Should You Rebalance💡 Definition:The process of realigning your investment portfolio back to your target asset allocation by buying and selling assets. During Market Crashes?

Market crashes stir emotions and panic, prompting investors to question their strategies and instincts. One such strategy, rebalancing, is a disciplined approach that can help investors maintain their intended risk💡 Definition:Risk is the chance of losing money on an investment, which helps you assess potential returns. profile and potentially improve long-term outcomes. But should you rebalance during market crashes? The answer is yes—if you’re prepared.

The Importance of Rebalancing

Rebalancing involves realigning the weightings of a portfolio's assets to maintain an original or desired level of asset allocation💡 Definition:The mix of different investment types in your portfolio, determining both risk and potential returns. During market downturns, your once-balanced portfolio can become misaligned. For example, if your investment strategy was a 60/40 split between equities and bonds💡 Definition:A fixed-income investment where you loan money to a government or corporation in exchange for regular interest payments., a 30% drop in equities could shift your portfolio to a 50/50 split. Rebalancing nudges you back towards your original allocation, ensuring your risk exposure remains consistent with your goals.

Why Rebalance During Crashes?

1. Risk Control💡 Definition:The process of identifying, assessing, and controlling threats to your financial security and goals.: Rebalancing enforces the disciplined practice of "sell high, buy low." As market crashes cause equities to drop and bonds to rise in relative value, rebalancing involves selling some bonds (high) and buying more equities (low). This practice helps lock in gains from the defensive assets and positions you to benefit from eventual market recoveries.

2. Avoiding Drift: Without rebalancing, portfolios can drift significantly from their target allocations. Historical data shows that a 60/40 portfolio left untouched could drift to 80% equities over time, vastly exceeding its original risk target. Maintaining your desired allocation helps control risk exposure.

3. Improving Returns: Studies indicate that rebalanced portfolios tend to have better risk-adjusted returns over time. During downturns, a rebalanced portfolio often loses less than an un-rebalanced one, cushioning the blow during volatile times.

Strategies for Effective Rebalancing

Pre-Crisis Planning

The key to successful rebalancing during a crash lies in preparation. Establish a rebalancing plan in advance, detailing when and how you will💡 Definition:A will is a legal document that specifies how your assets should be distributed after your death, ensuring your wishes are honored. rebalance. This plan removes emotions from the equation, allowing you to act logically during tumultuous periods.

Rebalancing Approaches

• Calendar-Based Rebalancing: This approach involves rebalancing on a set schedule, such as quarterly or annually. It’s straightforward and ensures regular review of your asset allocation.

• Threshold-Based Rebalancing: This method triggers rebalancing when asset allocations drift beyond predetermined bands (e.g., +/- 5%). It’s more responsive to market conditions and can be more effective during volatile times.

Consider Liquidity💡 Definition:How quickly an asset can be converted to cash without significant loss of value and Taxes

• Liquidity: Ensure you have sufficient liquidity to rebalance, especially during severe market declines. Illiquid assets can complicate rebalancing efforts, so account for this in your strategy.

• Taxes: Consider the tax implications of rebalancing. In taxable accounts, capital gains💡 Definition:Profits realized from selling investments like stocks, bonds, or real estate for more than their cost basis. taxes can impact the benefits of rebalancing. However, market downturns might provide opportunities for tax-loss harvesting💡 Definition:Selling investments at a loss to offset capital gains or up to $3,000 of ordinary income each year., potentially offsetting rebalancing costs.

Real-World Scenario

Imagine a portfolio valued at $1 million with a 60/40 allocation. Suppose equities drop by 30%, reducing the portfolio's value to $870,000, with a new allocation of 50% equities and 50% bonds. To rebalance:

• Sell Bonds: Sell part of the bond allocation to restore equity💡 Definition:Equity represents ownership in an asset, crucial for wealth building and financial security. exposure.

• Buy Equities: Use proceeds to purchase depressed equities, returning to the 60/40 target.

A study showed that in a similar scenario, a rebalanced portfolio lost $0.2 million less than an un-rebalanced one during a 30% equity drop, highlighting the benefits of disciplined rebalancing.

Common Mistakes and Considerations

• Emotional Decisions: Avoid knee-jerk reactions to market volatility💡 Definition:How much an investment's price or returns bounce around over time—higher volatility means larger swings and higher risk.. Stick to your pre-set plan.

• Ignoring Liquidity: Ensure you have enough liquid assets💡 Definition:Assets that can be quickly converted to cash without losing value—like savings accounts, stocks, and money market funds. to execute your rebalancing strategy effectively.

• Overlooking Taxes: Plan for the tax implications of rebalancing activities in taxable accounts.

Bottom Line

Rebalancing during market crashes is not just prudent; it's essential for maintaining your intended risk profile and positioning your portfolio for recovery. The key is preparation: establish a rebalancing strategy before volatility strikes, account for liquidity and tax considerations, and commit to executing your plan with discipline. By doing so, you can navigate market downturns more effectively and with greater confidence.