Rebalancing a portfolio is a tricky endeavor. There is no mechanical way to do it properly or perfectly. Each persons portfolio is different and the number of variables to account for are nearly impossible to identify. This leads the entire process to be more art than science.
A bear market adds an extra layer of psychological turmoil that you must overcome. Many question whether they should rebalance a portfolio in a bear market?
Yes, rebalancing a portfolio during a bear market is beneficial. The downward volatility of bear markets create new bargains to invest in. Meanwhile, certain stocks in your portfolio fall less drastically creating an opportunity to arbitrage.
Depending on your strategy of choice the parameters in which you decide to sell one stock for another may differ from another person. These variables can be confusing and difficult to navigate, but don’t worry by the end of this article you should be able to rebalance confidently.
Portfolio Rebalancing Explained
Portfolio rebalancing is usually done at the beginning or end of a year, either the January or December. This may be for tax reasons or to create a seamless data point to measure over time.
If you want a more standard explanation of portfolio rebalancing, Investopedia can probably help with that.
But, as value investors it is our duty to go against the herd and only rebalance on our own terms.
This means rebalancing whenever we want!
The general idea of rebalancing is to reduce risk, this is usually done to negate the risk associated with a single stock. Risk is measured by volatility and retirees want as little of it as possible.
For young investors, we want as much volatility as possible, preferably in the upward direction.
This makes rebalancing according to volatility completely useless and is one metric robo investing platforms use to rebalance your portfolio.
Rebalancing in a Bear Market
Typically rebalancing strategies in bear markets tweak the number of bonds vs stocks in a portfolio. Increasing exposure to stocks in a bear market can prove beneficial. However, in my case I only invest in stocks and have zero exposure to bonds.
This makes rebalancing a tad more difficult. Since I have to research individual stocks before deciding on a rebalancing strategy.
I constantly look to arbitrage my opportunity costs between different stocks, and bear markets make it much easier to do. But, its important to recognize what may be a bear market for you is not always a bear market for others.
Bear markets can be any of the following:
- Regional: According to what country your invested in.
- Industrial: Some sectors are up when others are down.
- Worldwide: When all markets fall together.
Bear markets can even happen according to the type of strategy you are using. For example, growth strategy can enter a bear market when a value strategy outperforms. But, this doesn’t mean you need to change your strategy.
Psychological Impact of Rebalancing in a Bear Market
The biggest hurdle to rebalancing in a bear market is selling shares that have lost value. After all your going against the creed: Buy low sell high.
This leads many to miss out on the best opportunities to increase stock returns.
People are constantly trying to shame others for selling into bear markets. Saying things like, “Your selling when its the best time to buy” or “If your scared during a market crash you shouldn’t be investing anyways.”
Just remember, your not a failure if you sell a stock. Doing so could cause you to boost returns by not missing a better opportunity. Let’s take a look at a few examples of where you might want to sell one stock to buy another.
Strategically Identifying Individual Stock Rebalancing Opportunities
So you may look a bit like the below photo right now, but I assure you, it will get better. I promise.
Depending on which strategy you are using there are different ways to look at stocks and ways to rebalance. A dividend strategy may differ from a growth or value strategy. In my case I choose to look at each stock holistically, which means according to all three metrics.
This is why rebalancing can become more art than science. Based on the weight you put on each strategy and the unique opportunities unforeseen outside the numbers, also known as catalysts, each person can attribute a different value to the same stock.
Rebalancing According to Dividend Yield
This is probably the easiest way to rebalance a portfolio. If you are retired and investing for dividends you can arbitrage dividend yields.
Company A may have had a yield of 1% while company B had a yield of 2%. In the event of a market crash company B’s yield has remained the same while company A’s yield has increased to 4%.
Note: This happens because one stock price falls while another remains fairly constant. I know weird, but it happens often.
This presents an opportunity to sell shares in company B to buy company A and increase your dividend payouts.
The most important variable in this situation is profitability and payout ratio. As long as company A retains a decent enough profitability and low enough payout ratio you can safely invest in it for added income.
Rebalancing a Portfolio According to Value
All strategies intersect a little and value rebalancing is no different from dividend investing. When rebalancing according to value it can be because the dividend got higher, or the PE ratio in relation to earnings growth (PEG) got better.
In my case I take in consideration all of the above, but more importantly I look at the balance sheet. Is the company trading at low multiples to book value?
If a company has dropped below book value while another trades above it, then the company below book value can sell assets to buy its own stock and increase shareholder value. In this situation it becomes far more advantageous to own the stock with immediate value than the stock with future value.
Rebalancing According to Earnings Growth
Growth investors often get it wrong. They don’t understand why one growth stock is any better than another growth stock. Peter Lynch in his book Beating the Street makes it simple by calculating the PEG with dividends included.
This can be done by taking earnings growth and dividing it by the PE ratio.
As a result you get a ratio that compares two growth stocks by value and profitability. When rebalancing try to sell a stock that trades above a PEG ratio of 1 and buy a stock that trades at a PEG ratio of below 1.
Hurdles to Overcome Before Rebalancing
If your still a little weary of selling a losing stock you can at least take solace in the fact that your tax burden has decreased. This is probably the best opportunity you have when rebalancing in a bear market. Talk to a tax professional to better ascertain the best benefit to you in this situation.
But, what if you are a buy and hold investor and selling would create a taxable gain?
This is where it gets trickier. At this point you will need to overcome the tax burden and it isn’t as simple as buying one stock to buy a cheaper one.
In this situation you will need to account for these variables:
- Is my portfolio too concentrated in one stock?
- Does the new stock have a large enough value gap to make selling worthwhile?
- Has it been over a year since I bought the stock?
The hardest of these questions to answer is probably the second as it relates to value gap. This question is incredibly subjective and only you can make the correct decision. It’s best to have a margin of safety by saying it has to at least be 50% better.
This way you can account for the tax burden and any miscalculations you may have made with the new stock.
A Wholistic Approach to Rebalancing
Depending on which strategy you value most its always best to account for all variables. If you don’t then the new value you think you are getting can quickly erode. For example if debt becomes an issue, no matter how much better of a deal stock 2 is, it will always lose if it goes bankrupt when your previous stock continues to chug along slowly.
Real World Example of Portfolio Rebalancing
I created this YouTube video to give you a better understanding of how I go about rebalancing my portfolio during any market.
Switching Strategies and Rebalancing
If you decide to switch strategies it can make sense during a rebalancing period but can also lead to underperformance. In my situation I switched from a large cap dividend growth strategy to a deep value strategy at the worst possible time.
This led to a period of underperformance that was psychologically draining. Mainly because I switched strategies quickly and impulsively and without really understanding what I was investing in.
This is why its important to rebalance as a part of your overall strategy, if you want to change your strategy rebalance only when shares become overvalued according to the old strategy, not the new one.
Be Confident in Rebalancing
It takes time to gain confidence in markets and many will never be completely confident. But, there will be situations where you uncover a stock that you know is unbelievably undervalued. In this situation don’t hesitate to rebalance whether it be a bear or bull market.