Many investors diligently save a portion of their income over extended periods of time. They also put a significant amount of effort into deciding which investments are appropriate for their needs. They potentially watch programs in the financial media, subscribe to publications, chat with their friends at the water cooler, and maybe even hire the services of a professional at some point. Having done so, they often ignore one of the most important aspects of portfolio management, rebalancing. What exactly does this mean and what are the benefits of portfolio rebalancing?

Put simply, the act of rebalancing ensures that your portfolio stays within your desired allocation over time. This is necessary because the assets in your portfolio will naturally change value over time and the percentage relationship with one another will change as a result.

The “middle of the road” investor who starts off with a 50/50 mix of stocks and bonds may experience substantial appreciation over time with the stocks and as a result the mixture is now 60/40. The investor is obviously happy to have experienced the increase in value in one asset class, although the portfolio overall may not be a fit for his risk tolerance. Rebalancing can get things back in order by trimming a bit of the highest performing assets (the stocks in this case) and purchasing additional bonds.

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Do You Have a Goal for Your Portfolio?

To begin our discussion of rebalancing, it might be useful to take a step back and address the fact that many investors do not have an overall goal or strategy for their portfolio. They evaluate individual investments one by one, selecting those they are attracted to, but not considering how the investments work with one another. They can end up with a portfolio that is arbitrary, made up of many high performing “stars” who do not make a team. There is no specific reason why an investment has a place in the portfolio and just as importantly, why the specific amount was chosen. This can make it very difficult to reach specific financial objectives and difficult to manage risk.

Think of a medication. There are directions on the label regarding how much to take, what symptoms can be treated and when to cease use. This can seem straightforward and easy to manage when addressing a single issue (a cold, for example) on a one-off basis. Now imagine you are on five different medications. There is a reason why the physicians prescribing each one wants to know what else is currently being taken and how much. This is because while each of them might address a need you have as a patient, they may not always be a fit with one another due to various side effects when used simultaneously.

Each Investment has a Purpose & Works Together

Your portfolio is very similar in that an effective design is not simply about choosing individual investments that you favor. Each investment certainly has merits that led you to consider it, but there may be no reason for all the investments to be owned together as a portfolio. To do this effectively you’ll want to address what your needs are as an investor and then select investments that best meet your needs. A key point to understand is that you are doing all of this while attempting to take the least amount of risk necessary to meet your goals.

What is Your Risk Tolerance?

Often investors who have selected their holdings arbitrarily and without consideration of the overall portfolio design may, in fact, have assets that are well suited to their financial objectives. They may, however, be taking more risk than necessary to meet their goals. Selecting investments by their place in an overall portfolio, often by choosing asset classes that are not correlated to one another can serve to reduce risk and increase the likelihood that an investors financial goals are met. (To eventually understand the benefits of rebalancing, we need to appreciate the benefits of a “balanced” portfolio to begin with.)

You Can’t “Set it and Forget it

Having selected an appropriately balanced portfolio with non-correlated asset classes chosen in proportion to one another to match a specific risk tolerance, it can be tempting to call it day. This is, after all, a lot of work up to this point! The investor who stops at this point will, unfortunately, run the risk of not meeting their goals. This is because they are only appropriately allocated at the beginning. As their investments are held for periods of time, they will drift out of balance with one another. This can happen as some assets go up while others go down or even if all assets go in the same direction but by different amounts.

If all our assets appreciated by the same amount, there would be no need to rebalance. A 50/50 mix of stocks and bonds would still be a 50/50 mix of stocks and bonds. The only difference would be the overall value. Since assets will perform at different rates, it’s likely that over time our mixture will change beyond the initial allocation we preferred.

Unfortunately, many investors do not rebalance at all or do not rebalance frequently, selecting their assets and forgetting them afterward. This can lead to portfolios that are arbitrary and may eventually no longer be appropriate choices for the objectives of the investor. How should you go about rebalancing to meet your objectives and what are the benefits of doing so?

Benefits of Rebalancing Your Portfolio

Select an initial allocation that you will periodically rebalance to. You should make sure that this initial allocation is a good fit for your risk tolerance and investment objectives. To reduce risk and take the least amount of risk necessary for the objectives you have, make sure to select a variety of asset classes that are not heavily correlated to one another. This means that your holding will not move similar to one another, smoothing out your investment experience over time. A focus on a single asset class or a couple that are similar could potentially lead to a bumpier road than necessary. Your decision will need to consider not only your future needs but any current needs such as a desire for income, as well as any tax implications relevant to your situation.

Make sure your initial allocation meets your needs for withdrawal or liquidation in the future. A specific date (retirement or a child’s education, for example) can be a crucial factor when choosing appropriate investments. If your funds do not have a specific predetermined function during your life (they are intended to leave a legacy rather than for your own use) you may wish to make your selections based on an overall risk tolerance rather than the eventual purpose of the funds.

Why is Investing Important?

Portfolio Rebalancing Frequency

Annually

Now that you’ve selected an appropriate “home base” to start from, how do you decide when to rebalance? For many investors, an annual rebalance is a good middle ground. This allows your portfolio to be altered frequently enough that it still meets your investment objectives while not so frequently that it creates unnecessary transaction costs or tax implications. Each year, you can look at your portfolio and sell enough of the assets that have appreciated disproportionately to the overall portfolio, purchasing additional assets that have not experienced as much appreciation since the last year.

Correlating inflows and outflows

If your portfolio has a known withdrawal or contribution, you can make sure your rebalancing coincides with the inflow or outflow of funds by selling or purchasing an amount of each asset that gets the portfolio back in balance. This can reduce the amount of activity necessary when current assets must be sold to purchase others.

Set a Range

While an annual rebalance might be a good starting point, it is possible that during the year certain assets might move enough to warrant action before. Many also choose to use a range within which an asset can drift before action is taken. If you want a 30% allocation to domestic stock, you might set a range of 25% at the low or 35% on the high end that if exceeded, would cause rebalancing to occur. This can prevent any asset class that has an unusual level of activity from upsetting the balance of the portfolio prior to the next scheduled rebalancing.

Be Flexible When Necessary

There are certain situations that might warrant changing your plans. Sometimes taking a large capital gain in the current year from the sale of a specific asset when there are not adequate losses to offset the profit can be minimized or deferred until the following year if a lesser tax burden is expected.

Why Portfolio Rebalancing is Important

The benefits you can potentially receive from rebalancing effectively are substantial. Of course, we don’t rebalance for its own sake, but to meet specific financial objectives. What is it we are attempting to achieve by going through this process? It doesn’t seem particularly intuitive since our natural inclination is often to let winning horses continue to run and show less attention to assets that have relatively underperformed. The primary advantage we can draw from rebalancing is managing risk.

Manage Your Risk

By managing risk, we can lock in some of the gains we’ve received and minimize loss in the future. Those new to investing often believe they are more comfortable with risk or that it matters less than is the case. They prefer to focus on maximizing returns rather than minimizing risk. This aspect of selecting investments is, after all, where the perceived profit can come from. Let’s also be honest that it’s just more exciting to look out for the potential outperformers than it is to find ways to protect your established basket of existing selections. What is the big deal with risk management? Why devote your energies to rebalancing or any other risk management technique? One simple answer is math.

Example #1

The numbers are very advantageous for those who keep an eye on their downside over time and very unforgiving to those who do not, even if these individuals have had unusually good years. Assume for example that an investor has a lump sum that they invest in a highly aggressive fashion. The first year he is up 20%. He decides not to rebalance and keeps the assets as they are currently and the second year he is down 20%. He’s even, right? Not so fast. The investor would be at 96% percent of the initial opening balance, meaning he is down by 4% even though his percentage returns were the same each year, albeit in different directions. (The first year was positive and the second year was negative.) This is because after the first year there is a larger balance to fall from. The same percentage on the way down will take more dollars from the investor than he received on the way up.

Example #2

A similar investor paying attention to risk management and using a rebalancing strategy would sell off some of the highest performing assets after the first year (or whenever a “range” had been exceeded) and purchase more of the lower performing asset classes. The range within which the portfolio would fluctuate would be contained and could potentially result in lower returns in some years, although the risk management would likely ensure that the investor has a higher expected return for the amount of risk he is willing to take in the long run.

Conclusion

The process of rebalancing can be complex. You’ll need to consider when and under what conditions to rebalance. You’ll also want to determine what are appropriate ranges to allow assets to drift. Depending on your accounts, you may be doing all of this while either adding to or drawing from the portfolio. This can be a challenging process that some have the time for and enjoy performing themselves. Others find they would like professional guidance with designing their portfolio and rebalancing it over time, but also with addressing those needs within the context of an overall financial plan that also addresses taxes and other relevant issues that can be affected by these and other portfolio decisions.

If you’d like to discuss how to effectively rebalance your portfolio as well as how this decision may fit into several other aspects of your financial life, consider a consultation with a CERTIFIED FINANCIAL PLANNER™ professional at Pure Financial Advisors.

 

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Disclosures

Intended for educational purposes only and are not intended as individualized advice or a guarantee that you will achieve a desired result. Before implementing any strategies discussed you should consult your tax and financial advisors. 

Investing involves risk including the potential loss of principal. No investment strategy can guarantee a profit or protect against loss in periods of declining values.