Run your rebalancing rule through a made-up crash and recovery and see what it tells you to do at each step.
Test your rebalancing rule on paper, against a crash you make up, before you rely on it in a real one. You can't know how you'll behave in a crash until you're in one, but a rehearsal on paper takes you closer. The exercise takes about 25 minutes.
Start with a portfolio of S$100,000 (an example figure) split at your own target. Round numbers keep the arithmetic easy to follow. Don't add any new contributions along the way, so that the only thing changing your percentages is the rule itself.
Then run the portfolio through this crash path. Over the first year, shares drop 35% in two stages: 20% in the first six months, then a further 18.75% in the six months after that. Together these leave shares at 65% of where they began. Over the following two years, shares climb back to their starting level, gaining about 11.4% every six months. Bonds stay flat from start to finish.
A real crash will be messier than this, but the path keeps the three parts that test you. There is the first fall, then a second leg down (a further fall that arrives just when you'd decided the fall was over), and then a slow recovery.
On every check date, work through the same four things and write each one down:
the new value of your shares and of your bonds the percentage of the total that is in shares whether that percentage triggers your rule the trade that takes you back to your target split, if the rule triggers
How you handle check dates depends on the kind of rule you set. Under a calendar rule, you trade back to target on every check date. Under a threshold rule, you trade only when shares move outside a set band, and you should check as often as you will actually check in real life.
Farhan (an invented investor) keeps 65% of his portfolio in shares and 35% in bonds. He set his rule in Lesson 6.2, "Calendar or threshold rebalancing". He looks at the portfolio each January and July, and he rebalances to 65/35 when shares are above 70% or below 60%. The rule reads well, but he has never had to follow it through a real fall. He puts S$65,000 into shares and S$35,000 into bonds and runs the crash, with all values rounded to the nearest dollar.
By July of year one, shares have dropped 20% to S$52,000. Bonds are still S$35,000, so the total is S$87,000 and shares make up 59.8% of it, just under the 60% floor. The rule triggers. Farhan sells S$4,550 of bonds and buys S$4,550 of shares, which returns him to 65/35.
By January of year two, shares have fallen a further 18.75% to S$45,947, and bonds stand at S$30,450 after the July trade. The total of S$76,397 is the lowest point in the whole test, about 24% under the S$100,000 he began with. Shares are 60.1% of the total. That is inside the band, so he doesn't trade.
The rule calls for no more trades after that. Shares reach S$51,171 (62.7%) in July of year two, S$56,990 (65.2%) in January of year three and S$63,470 (67.6%) in July of year three. By January of year four they are back at their starting level and worth S$70,687, which is 69.9% of the portfolio and still just inside the band.
His portfolio finishes at S$101,137. A portfolio that was never rebalanced finishes at exactly S$100,000, because shares end where they started and bonds stayed flat. The whole S$1,137 gap comes from the S$4,550 of shares he bought near the start of the fall.
This result comes from one made-up path, and it says nothing certain about real markets. Rebalancing keeps you at the level of risk you chose, and it carries no promise of gains. It can also leave you worse off than doing nothing, for example when a fall goes on for years.
Hard moments come in two kinds. In the first, the rule tells you to take money from the steady asset and put it into the falling one. In the second, the rule tells you to do nothing at the bottom. Sitting still at the bottom feels as wrong as buying, because your instinct is to act and the first action that comes to mind is selling.
For Farhan, July of year one is the worst point. His shares have just lost S$13,000, the headlines are grim, and he has no way of knowing the fall is only half over. The rule asks him to move money out of the stable part of his portfolio and into the part that is collapsing. Six months later, the S$4,550 he moved into shares has fallen by almost a fifth. At this point he would be most tempted to break the rule, or to quietly decide to skip it at the next check.
January of year two is hard for a different reason. He is at the bottom, about 24% down, and the rule asks him to do nothing.
Where your own hardest moment falls depends on your rule. A calendar rule may ask you to buy shares at more than one bad moment. A threshold rule with a narrow band may set off more trades on the way down. Go down your record line by line, decide where sticking to the rule would feel worst, and mark that point.
Write the note now, while you're calm, in words that sound like you. Base it on your plan and leave out any view about where markets are heading. Keep it short enough to read in ten seconds. Don't put in anything that predicts the market, such as "it always recovers", because you control your plan and you have no control over a forecast.
Farhan wrote: "I chose 65/35 knowing a fall like this would come. The rule is how I keep the risk I chose, and selling now would turn a loss on paper into a real one."
When your note is written, read it again as the person you would be on the worst day of a real crash, and ask whether that person would find it convincing. If they wouldn't, rewrite it and read it again in their place until they would be convinced.
Now run your own rule through the same crash, record each trade, and mark your hardest moment. At that hardest moment, what words would keep you following the rule? Write them now, in your own voice, while you are calm. Keep them short enough to read in ten seconds.
Fill in the crash test sheet for your rule. Then write a two-sentence note to read before you rebalance in a real fall.
Junxiong-WFG Organisation is an authorised representative of AIA Financial Advisers Private Limited (Reg. No. 201715016G).