Let's talk about reason number three why we rebalance - to adjust for the changing financial world we live in. Now, I want to be very clear that this is not market timing. When we say "adjust to the changing financial world," we're not saying, "Oh, I gotta rebalance and I gotta go from all equities to all conservative investments," or vice versa. Remember, when we move through our life cycle of investing, it is a glide path, not a glide cliff. If you find someone who's constantly flipping your portfolio back and forth between different portfolios, then they are not using rebalancing as an investment tool. Instead, they are timing the market, and studies suggest that this is not likely to set you up for success over the long term.
But let's give some illustrations. I want to talk about some of the big macro things that we're talking about, starting with interest rates. One of the hardest things to do as a professional financial advisor and asset allocator for our clients over the last 10 to 15 years is to deal with historically low interest rates. The problem with taking cash to pretty much zero to stimulate the economy is that anybody who's approaching retirement can't get yield from buying cash bonds; the yield is not there. The only way to capture a good long-term return is to go further out on your risk spectrum and still asset allocate. Fortunately, this is one of those silver lining moments where lemons turn into lemonade. When interest rates have been pushed up so rapidly to fight inflation, it's not uncommon for cash, bonds, and other investments to get historic reasonable rates of returns again. Now you can get over 4% on your cash, and it's not uncommon for bonds to get back to a 5-6% rate of return without taking a lot of risk. This allows for much more balance in your asset allocation.
You have to pay attention to these big macro events because if you're not paying attention, you wouldn't realize that this is a time to rebalance and adjust for some of these changing things, like higher interest rates. Another interesting example is valuations within market cycles. It's not uncommon, maybe we just came through a large downturn, and maybe interest rates are low. When you start thinking to yourself, "You know what, in a low-interest rate environment where the cost of capital is low but the economy is looking to improve, maybe instead of having a lot of my portfolio in large US companies, I think that small US companies might outperform coming out of this bear market." If you have that position and think it could take place, rebalancing provides a mechanism where you can take advantage of that, where you can look at price-to-earnings ratios. Are we already in the bear market, or are we in the bull market? How do I factor in yield in my portfolio versus capital appreciation? Rebalancing systematically gives you an automatic time where you can look at these things and take advantage of them as they present themselves inside of your portfolio.
Another thing that rebalancing allows you to do is to look at big macro events like geopolitical events, whether that be international conflict or things going on in other countries that could impact your portfolio. Again, this is not a mechanism to time the market or try to make rapid movements. But if you are systematically rebalancing, you can make sure that your portfolio doesn't get completely out of whack. Over the last decade or so, it's been not uncommon that US domestic markets have outperformed international markets. If you had a domestic and international portfolio and you did not rebalance, you're probably overweighted in domestic investments and underweighted in international ones.
For more information, check out the full episode called, "Watch This Before Rebalancing Your Investment Portfolio!"