Welcome to part six in the intermediate guide to investing! In the previous part, we learnt about planning financial goals that are achievable and coming up with a preliminary portfolio allocation to achieve those goals while respecting your risk tolerance.

Also, if you haven't yet read our beginner's guide to investing, where we introduce things like why you should invest, how to start investing, as well as risks, rewards and strategies, do check it out first!

Why Invest? - Beginner’s Guide To Investing (Part 1) | Investing For Two
Welcome to the first part in Investing For Two’s beginner’s guide to investing! It’s always an exciting journey to learn something new, and investing is something you definitely want to pick up earlier rather than later in your life. This guide will walk you through the basics of investing, all the…

Chapters in this guide:
Part 1 - Why Read Financial Statements?
Part 2 - How To Read Financial Statements
Part 3 - 10 Key Financial Ratios & Metrics
Part 4 - How To Analyze A Stock
Part 5 - Portfolio Management & Asset Allocation
Part 6 - Portfolio Rebalancing & Market Conditions
Resource - Stock Analysis Checklist

We all know that markets change with the times. Traditional investing seeks to develop an all-weather portfolio allocation, which presumably gets investors through most changing market conditions.

However, it might be better to rebalance your portfolio allocations to adapt under different market conditions, ensuring that your portfolio can play to the strengths and avoid the weaknesses of various market conditions.

In this part, we will examine why portfolio rebalancing is important, as well as how to rebalance your portfolio in response to various changing economic regimes. We will further examine two different types of rebalancing - preemptive rebalancing and reactive rebalancing.

Why rebalance your portfolio?

While having an all-weather portfolio allocation sounds nice, the reality is not so simple. The concept doesn't stand, because all asset classes (equities, bonds etc.) have varying levels of performance in different economic conditions, as seen in the previous part of this guide.

As such, depending on our portfolio allocation, different portfolios perform differently in various economic situations as well.

In particular, a portfolio well suited for a certain economic situation may underperform in another economic situation.

For example, a portfolio tailored for protection during deflationary market conditions will underperform if the market situation changes to an inflationary one, since it will not adapt well to take advantage of any increase in growth.

Simply put, no particular portfolio allocation can perform excellently in all market conditions. Therefore, if we spot a change in economic regimes, rebalancing our portfolio is recommended to ensure that it stays resilient in the face of changing market conditions.

The act of portfolio rebalancing protects us both from taking on too much risk and suffering from heightened drawdowns, and prevents our portfolios from underperforming too badly as conditions change.

The various market conditions

In general, we have four main major market conditions or economic regimes.

Types of economic regimes
Types of economic regimes

Good growth

This is the market condition that we see most often - and that's a good thing. In general, we want our economy to grow stably. This means that we see high growth and low inflation, which allows for people to continue spending.

Remember, inflation is the increase of prices for goods and services. We don't want it to increase too quickly (high inflation), because this causes goods and services to become highly expensive, discouraging spending.

If nobody spends, the economy becomes stagnant as people hoard money, causing the economy to crash.

Generally, good growth signals that the general public is spending well, and inflation is within control. This contributes to increased and sustainable economic growth.

You usually see this economic regime occur right after a recession, as the economy is bouncing back and investors are positive about the market.

In periods of good growth, portfolio allocations that lean towards performance seeking tend to do well, since they capitalize better on the growth.

Inflationary growth

Here's where it starts looking a little risky for investors. As the economy continuously grows, investors expectations begin to be strained.

Due to continuous growth, the economy is doing well, and unemployment levels drop. As a result, spending power goes up and demand increases. As demand increases beyond supply, prices rise, which in turn lead to rising inflation rates.

A high inflation rate coupled with strong economic growth is not sustainable, as the strong economic growth would push inflation rates even higher as it creates greater demand.

Of course, this economic regime quite rarely happens, since government policies attempt to keep inflation rates within a manageable level, usually within 2%.

In periods of inflationary growth, portfolio allocations that lean towards performance seeking will take a hit since inflation drives up the cost of goods, resulting in lower company profits.

Recession

On the opposite end of the spectrum, we have a recession, a very scary economic regime for any investor. A recession occurs when there is low inflation (or even deflation - negative inflation), and low or negative growth in the economy.

We have an article covering why recessions happen. During this period, GDP falls drastically, usually resulting in increasing unemployment levels that lead to a decrease in spending power and hence reduced inflation as supply exceeds demand.

Since there is little growth, portfolio allocations that are highly performance seeking will suffer tremendously. Liability hedging portfolios tend to perform better here, with more defensive positions in constant paying securities like bonds.

Stagflation

Finally, we have a strange economic regime that rarely ever happens. In fact, stagflation was thought to be impossible by traditional economic theories, until it actually happened.

In periods of stagflation, there are high unemployment rates, resulting in reduced spending and low economic growth. However, there is somehow still a high inflation rate. The opposing cause and effect is unnatural.

The high inflation rate can be caused by a result of government policies and funding to prop up the economy, or when the economy faces a supply shock, which can cause prices of commodities to change wildly.

For example, when oil experienced a supply shock, the prices of crude oil increased dramatically, resulting in high inflation as a lot of products depend on oil (for production and transportation), raising the cost of producing goods.

However, when a recession occurred due to the rise in cost of goods, the government used excessive fiscal policies to stimulate the economy, increasing the money supply dramatically which further heightened inflation rates.

These two factors resulted in stagflation - high unemployment, low spending, low growth, but high inflation rates.

In such an economic regime, most portfolio allocations won't do well since investors' expectations are bearish. Liability hedging portfolios might do better here.

When to rebalance your portfolio

As we take a look at all four of these economic regimes, it becomes clear that they are demarcated based on how the economy is behaving at the moment.

As such, it is inevitable that we need to be able to have some foresight on how the economy is performing in order to prep our portfolio ahead of time.

Portfolio rebalancing helps significantly if you're able to rebalance before the economy has been affected, such as a change from one economic regime to another.

That said, markets do not perform exactly as economic theory dictates them to, since they are affected broadly by investors' expectations and government policies. Experts may be able to predict the market to some extent but it is never a 100% accurate.

As an example, during the coronavirus pandemic of 2020, despite all-time high unemployment rates and significantly reduced spending due to social distancing measures, the economy rose due to extreme financial measures from the US government to prop up the economy.

Clearly, perfect economic foresight is impossible - or everyone would be rich. But even imperfect economic foresight is difficult to achieve due to the seemingly random nature of the markets.

Information coefficient dependent on economic foresight
Information coefficient dependent on economic foresight

The information coefficient relates to how different the expected stock prices of an investor compares against the actual stock price. An information coefficient of 1 dictates that the prices match exactly (good news) and vice versa for low coefficients.

In this graph by J.P. Morgan, we see that imperfect foresight still gives pretty good returns in terms of adaptation to market changes, while bad foresight can have a negative effect instead.

Although perfect economic foresight may be hard to achieve, we can still strive for imperfect economic foresight and rebalance our portfolios to increase our portfolio's adaptability according to broad market sentiments.

This type of rebalancing can be termed as preemptive rebalancing - restructuring your portfolio to better prepare for upcoming market conditions.

This can be a risky endeavour as a wrong prediction can result in you getting significantly worse results then if you didn't rebalance at all. After all, we always say that we shouldn't try to predict the market.

If we're unable or unwilling to conduct rebalancing preemptively, we can consider reactive or responsive rebalancing. In general, this form of rebalancing waits for a change to occur that deviates from our plan, then adjusts our portfolio back to fit the plan.

This is a more passive form of rebalancing that incurs less risks, and should be conducted at predetermined time intervals on a regular basis (preferably every month).

Let us examine both preemptive rebalancing and reactive rebalancing in greater detail.

Preemptive rebalancing

Rebalancing your portfolio preemptively is a 3 step process - identifying changing market conditions, evaluating how asset classes might change in relation to it, and finally rebalancing our portfolio to take advantage of the market condition.

Firstly, we need to identify the general economic situation and generate an imperfect forecast of it.

The "how" of doing this varies, but generally, you should at least keep yourself abreast with the latest news and happenings. At the same time, you need to monitor your portfolio.

Any sudden changes or dips could signal the start of an economic regime change or volatile market conditions. The earlier we can spot a regime change, the better, to have more time for rebalancing.

In step 2, we need to determine how the asset classes we hold or plan to hold will adapt or change to the forecasted (or currently occurring) market condition.

Below is a table of how various asset classes generally perform in response to different economic regimes that can be used as a preliminary base (for information purposes only).

Performance Good growth Inflationary growth Recession Stagflation
Best Equities, Real Estate Commodities Cash, Bonds Bonds, Commodities
Average Commodities, Bonds Equities, Bonds, Real Estate Commodities Equities, Real Estate
Worst Cash Cash Equities, Real Estate Cash

Note that asset classes may respond differently to different economic scenarios. For example, while equities may dip significantly during a recession, if the ones you hold have a low beta, then they may not respond as expected.

Similarly, special economic situations might see various industries and sectors perform in different ways, affecting their respective asset classes differently.

Do evaluate the asset classes you plan to invest in accordingly in response to the economic regime that you expect (aka don't rely on the above table too strictly).

Finally, in step 3, we can perform our portfolio rebalancing with regard to the above two steps. Assess the effect of the expected economic regime in relation to your current portfolio, and then make the rebalancing necessary to adapt your portfolio to the changing market conditions.

For example, if you expect a recession to happen shortly with a worrying degree of confidence, then you would take on more defensive positions such as buying into bonds and hoarding cash instead of buying more risky equities in the short term.

As economic regimes change, it can be difficult to continue hitting our return expectations in line with our financial goals in the previous part. Rebalancing is the "next best thing", helping us to reduce losses and take advantage of recoveries.

Reactive rebalancing

Adapting our portfolio in preparation for certain expected economic regimes may seem like trying to time the market. Indeed, a lot of investors like to avoid this risk, since no one can really predict the market, even imperfectly.

For more passive investors, rebalancing can be a way of keeping to your financial goals and original portfolio allocations as well without forecasting economic regimes.

In general, rebalancing simply exists to ensure that your portfolio remains on your desired portfolio allocation, and it is up to you to determine what that allocation should be.

Since this asset allocation is what we have predetermined in the beginning to be optimal for our financial goals and risk tolerance, we should stay within these allocations to avoid unnecessary risk.

This is the whole reason for reactive rebalancing - to keep your portfolio on track within the limits and asset classes that you are familiar and comfortable with. For most individual investors, we would recommend this form of rebalancing instead.

In reactive rebalancing, we are focusing on ensuring that the allowable percentage of asset classes in our original portfolio allocation stays the same.

Every asset class in our portfolio is given a certain percentage allocation by value, and the allowable range of movement (e.g. +/- 5% deviation).

At the time of rebalancing (e.g. if we rebalance on the 15th of every month), we will see if any of our asset classes has changed in value from our target allocation.

For example, if a recession occurs, our equities will usually fall in value. Let's say our original portfolio allocation calls for 40% equities, but with the drop in share prices, our equities allocation now totals 30% of our portfolio value.

In our original allocation, we allowed a +/- 5% deviation for equities. Now that it has fallen beyond the deviation limit, we have to rebalance our portfolio to maintain our original asset allocation strategy.

We will therefore buy more equities (or sell other asset classes) to ensure that our equities makes up 40% of our portfolio value again.

The beauty of reactive rebalancing is it helps you to take your emotions out of the equation. By going purely by percentage value, you will sell if an asset class goes up (thus cementing some returns), and buy if an asset class goes down (get value at a discount).

When rebalancing, an important decision to decide when to buy and when to sell in order to rebalance. As a long term investor, the general goal is never to sell until retirement in order to grow our profits over the years.

Of course, there are exceptions, such as if a particular financial instrument loses its value. It might be worth it to cut losses and find a better investment. This is, in the end, entirely up to you.

The following are a few popular portfolio allocation strategies that you can consider adopting in various market conditions.

Bogleheads three-fund portfolio

The Bogleheads three-fund portfolio is a public favourite, becoming quite popular among investors for its simplicity and effectiveness.

Generally, it's simply a collection of equities and bonds, both international and local. In particular, the equities portion is comprised of index funds (such as ETFs), thus achieving diversification to a certain extent.

In addition, the equities portion help to further diversify your portfolio by including equities from different markets and conditions, such as having a portion from emerging markets, and another portion from developed countries.

Check out our guide on popular diversified ETFs to build up the international equities portion of this portfolio.

This portfolio is great for passive investors who do not like to track their portfolio all the time since it simply follows the market and its ups and downs.

Index fund (International/Worldwide) Index fund (Local) Bonds equivalent
60% 30% 10%

Note that you can vary the percentage allocation as you see fit. For example, if you like local equities better, feel free to add more into local index funds.

Balanced

For the average investor who just wants decent returns at decent risk, this portfolio excels at being average - which is not a bad thing!

This portfolio performs decently in all scenarios, but doesn't protect as well when the market is doing badly.

It consists of a larger weight towards equities, both dividend paying and growth focused, while also incorporating real estate, REITs and bonds if necessary.

Equities Real Estate Bonds Commodities Cash
40% 20% 20% 10% 10%

Aggressive performance seeking

For those who have high risk tolerance, don't be afraid to seek greater profits (while knowing what you're doing). This portfolio seeks high returns while having high risk, and is highly sensitive to market fluctuations.

This portfolio performs the best when the market is doing well, and crashes dramatically when the market is bad.

This portfolio prioritizes stocks, options and real estate, with low or zero allocations to liability hedging products.

Equities Real Estate Bonds Commodities Cash
75% 20% 0% 0% 5%

Defensive liability hedging

On the opposite end of the spectrum, if your risk tolerance is really low, you will want safe products to give decent returns while avoiding risk.

This portfolio performs the best in times of economic uncertainty (e.g. recessions), but under performs if the market is doing well.

It usually contains a mix of bonds (retirement bonds, government bonds), ETFs, real estate, dividends aristocrats and commodities like gold. You can also consider adding stocks with low beta.

Equities Real Estate Bonds Commodities Cash
30% 20% 30% 10% 10%

Constant income

For people who don't like to sell to get profits, this is for you. Earn constant cash flows to offset your liabilities to maintain liquidity.

This portfolio underperforms in stock market growth, but doesn't burn as badly if the market is doing badly either (although dividends could be cut).

It usually consists of dividend paying equities, ETFs, REITs, real estate and a small amount of bonds (optional).

Equities Real Estate Bonds Commodities Cash
50% 40% 10% 0% 0%

These are just some popular suggestions to structure your portfolio. Your financial goals are different and it must be up to the individual investor's risk tolerance, time horizon, goals and other factors to determine the appropriate portfolio allocation.

Note that these portfolio definitions are just broad denominations in terms of asset classes. Within each asset class, there are still various assets that can behave differently in various economic and market conditions.

For example, within the equities asset class, we still have equities from emerging markets, developed countries and more. Within the fixed income (bonds) asset class, we have government bonds, corporate bonds etc.

In addition, there are also further classifications within each asset class with different risks and rewards. For example, equities can contain blue chip stocks (large, stable companies) and small caps (small, listed companies), and small caps tend to crash more significantly during recessions than blue chips.

When planning your portfolio allocation and rebalancing in accordance with your risk profile, make sure you consider not just the asset classes, but the sub-classes within them as well.

For example, if you plan for your portfolio to have 50% equities, for diversification purposes and depending on your risk profile, you may wish to have 40% assigned to blue chip equities and 10% assigned to small cap companies, or 30% to emerging markets and 20% to developed markets.

When rebalancing, make sure to continue upholding this ratio in order to stick to your originally allocated plan where you have already accounted for your risk tolerances.

Summary

Thanks for reading the last part of our intermediate guide to investing!

In this part, we looked at portfolio rebalancing and the various economic regimes that we may encounter as investors. Portfolio rebalancing is a necessary act in order to adapt our portfolios.

Note that portfolio rebalancing for various economic regimes is not something that is done alone. It is to be done in relation with your original financial goals, as well as the original portfolio allocation that you set out to achieve.

Remember, your portfolio allocation must reflect your financial risk tolerance and other factors. You should not drastically change your allocation just to rebalance and fit the economic situation.

Instead, slight tweaks to your original allocation to better take advantage of the various economic regimes is recommended in addition to your original portfolio allocation and planning.

Portfolio rebalancing serves as a supplement, not a modification. When rebalancing, do decide if you want to do preemptive rebalancing, or just reactive rebalancing alone.

For most passive long term investors, reactive rebalancing is often enough so that you incur less risk, although there may be lesser returns. Buying extra assets to rebalance is also often preferable to selling assets (ideally, we hold forever to let our investments grow).

It is also best if you rebalance frequently so that your portfolio remains resilient in the face of change. We must therefore monitor our portfolio occasionally to see if the average returns we are getting are on target.

So far, from the beginner's guide to now, we have covered why you should invest, the risks, analyzing stocks, reading financial statements, and the basics of portfolio allocation and rebalancing.

If you've made it this far, you would have realized that investing takes a lot of work, and we have barely touched the tip of the iceberg!

As such, investors these days tend to prefer passive investing over active investing due to its relative simplicity.

What is passive vs active investing, their differences, and why you would pick either method? Check out our article to find out!

Passive Vs Active Investing | InvestingForTwo
If you’re new to investing, welcome! In this article, we will be discussing the differences between active and passive investing. You may have noticed that we have a beginner and intermediate guide to investing on our blog, which will run you through how to invest, analyze stocks and manage your po…

PS: We also have a stock analysis checklist for you to see if a stock is attractive to invest in or not (use it as a baseline only). Check it out below, it's free!

Stock Analysis Checklist | InvestingForTwo
This is a checklist of things to check to see if a stock is good for investing or not. It provides a suggestion of financial metrics, ratios and other factors to take note of when analyzing a stock that you want to invest in. For more in-depth explanations on this checklist and the various financia…

If you enjoyed, do subscribe to our weekly newsletter below to get a roundup of our latest posts and other goodies. No spam, promise! You can also follow us on Facebook, Twitter or Instagram for the latest updates.

Additionally, sign up as a member for access to 0 premium posts or support us by making a small one time donation to support our work! We really appreciate it! 🙂