You are probably aware that a major determinant of your investment returns, as well as your portfolio risk and volatility, comes from the proportions of various asset classes or investments that you hold. As such, you likely gave a good deal of thought to your initial selection of what investment mix to hold in your portfolio.
But what do you do after you’ve set that initial allocation?
What comes next?
Portfolios Drift Over Time
Imagine a hypothetical $100,000 portfolio consisting of 50% stocks and 50% bonds, so that at the start you own $50,000 worth of stocks and $50,000 worth of bonds. Let’s assume that the stocks return 10% each year and the bonds return 5%. The table below shows the dollar value of stocks and bonds that you would own over time:
| Year | One | Two | Five | Ten | Twenty |
| Stocks | 50,000 | 60,500 | 80,525 | 129,687 | 336,374 |
| Bonds | 50,000 | 55,125 | 63,814 | 81,444 | 132,666 |
This example is for illustrative purposes only.
As you can see, after two decades, your 50/50 mix of stocks and bonds is now 72/28!
The good news is that in this scenario you’d have a lot more money than when you started. But the bad news is that you also have a lot more exposure to the stock market than you initially wanted. This is important, because in general, stocks carry more risk than bonds.
This increase in your allocation to risky assets is ok if your goals and risk tolerance have changed, but in many instances this drift occurs even when you aren’t trying to increase your exposure to a particular asset class. In some instances, you might even find that your portfolio has moved in the exact opposite direction you intended.
Good Times, Bad Times
Here’s the problem: think about when a portfolio allocation is most likely to move significantly out of alignment; its probably after a big bull or bear market. In other words, an allocation to an asset class is most likely to be higher than intended following a significant run up in prices. Conversely, an allocation is most likely to be meaningfully underweight after a sharp selloff. Basically, this is like buying high and selling low.
But – and this is the important part, the goal in investing is to buy low and sell high, which is the exact opposite of what happens if you don’t rebalance your portfolio.
Rebalancing Approaches
If the above demonstration has convinced you that rebalancing your portfolio makes sense, then there are several different ways to do so.
The first, and simplest, is to rebalance according to the calendar. In other words, you periodically look at your portfolio and make any needed adjustments. For instance, maybe each December you go in and sell or buy an investment or asset class as needed. This is better than not rebalancing at all, but the problem with that approach is that market fluctuations don’t perfectly align with the calendar. An obvious example of this was in 2020, when the stock market experienced a 40% COVID selloff in the spring before ending the year higher. In that instance, the time to rebalance the portfolio was in early 2020, not at the end of the year.
S&P 500
Because of that, we think that a better approach is to rebalance your portfolio based on how far you are willing to let an investment deviate from its desired allocation. You set the target, and then if it moves too far from that target, a trade gets signaled. For instance, if you wanted to have a 50/50 stock and bond allocation, maybe you’d be willing to let those weightings fluctuate 10% in either direction. So, your portfolio could float between 60/40 and 40/60, but if it exceeded that range, a trade would be executed to bring it back into that 50/50 alignment. Rebalancing in this manner takes more effort on your part, but is more likely to keep your portfolio aligned with your risk and return goals.
Rebalancing as Part of a Broader Portfolio Management Approach
Whatever approach you choose, keep in mind that rebalancing is only one component of the overall portfolio management program. For instance, you might also have cash coming into the portfolio, or distributions might need to go out. In those instances, you could use inflows to purchase underweighted securities, or outflows to sell overweight positions, even if portfolio weightings haven’t tripped your preset rebalancing bands.
Taxes also play a role in managing many portfolios. That means that you might need to coordinate your rebalancing approach with the potential tax implication of a transaction. At times this may mean that perhaps you don’t execute a trade in a taxable account. Instead, you place a corresponding trade in your IRA or other tax advantaged account. The result could be that both the taxable account and IRA appear to be out of alignment when viewed individually. But, when you look at your portfolios holistically, they are in balance.
The bottom line is that a set it and forget it approach to portfolio construction is unlikely to produce the results you desire. Consistent rebalancing, incorporating cashflows and in coordination with tax management, is vital to maintain your desired risk tolerance while still meeting your required rate of return.
Next Steps:
- Review your account(s) to determine if your asset allocation and investment mix is in line with your strategic allocation.
- Determine what rebalancing bands you want to use going forward, then set portfolio alerts to trigger action if those bands are breached.
- Take a deeper dive into your overall financial situation by signing up for our free financial assessment: https://purefinancial.com/lp/free-assessment/
