Rebalancing discipline– through good and bad times

Equities have continued to shine this year.  Given stock-market-momentum, it’s likely a good time for many investors to rebalance their portfolios.  Rebalancing is the action of adjusting a portfolio’s asset class allocations from its current weightings–determined by market forces–back to the policy’s optimal weights.  In this blog we briefly explain the significance of this important but often neglected investing discipline.

Correct Balance

Portfolio management assumes that there is a correct balance of securities (aka asset allocation) that is suitable for each investor.  How you divvy up stocks, bonds, and cash reflect both the desired return and risk (for this purpose the ability to stomach volatility) for your portfolio.  An investor’s investment policy statement lays out these normal, broad asset class weights appropriate over the long haul. Any portfolio that consists of securities with different returns will drift away from its target asset allocation and tend to increase portfolio risk. A trending stock market exacerbates this drift in portfolio weights. 

 Investor Behaviour

 Investors are often loath to rebalance during a bull market for stocks.  Hesitant to sell shares after an exceptional run they end up with a portfolio overweight to equities and more susceptible to stock-market corrections.  If it helps, remember that taking profits after a big run is not the same as missing out on the market.

 We do not subscribe to allowing the stock market to dictate investment policy, i.e. set-it-and-forget-it portfolio.  Why?  Because an investor’s experience during a market down cycle could be significantly different than expected.  Imagine a portfolio originally allocated 40 percent fixed income/60 percent equity, that drifted to 20/80 debt/equity after a sustained market run-up, only to be followed by a sharp 20 percent market correction.  The allocation drift would result in a 4 percent greater loss.

 Luckily rebalancing runs counter to our irrational human nature. It forces investors to buy low and sell high: profiting off gains from outperforming investments while paying lower prices for underperforming ones.

Investors should decide on the rebalancing rule when their heads are clear, and not in the middle of a market meltdown.  During periods of market turmoil, investors face enough psychological pressure of succumbing to fear and risk making ill-timed decisions to sell.  A better alternative is to practice systematic rebalancing.

 Triggers & Strategy – calendar or threshold

There is no hard-and-fast rule about the frequency of rebalancing.  Calendar-based triggers are common–rebalancing on a predetermined frequency. Threshold rebalancing, in contrast, depends on a predefined trigger that is independent of time.  

 Studies find that in most instances, relatively infrequent rebalancing (on the order of once a year or so) and relatively high rebalancing thresholds between the broad asset classes of fixed income and equities (of about 10 percentage points) will be sufficient to contain the risks without resulting in an inappropriately high drag on returns.

 Balancing Act

The portfolio rebalancing decision is multi-faceted; with benefits and costs hanging in the balance.  The benefits of rebalancing must outweigh the costs, such as transaction costs and tax consequences.  But do not become so focused on costs and lose sight of the more critical risk issues. 

Rebalancing is often a natural by-product of portfolio management.  To help minimize costs in the process, consider using incoming cash deposits and contributions or interest and dividend income generated by the portfolio.  Also gains are best reaped inside registered retirement accounts, with tax deferred until you make withdrawals.

Results Orientation

A rebalancing strategy may also depend on orientation.  Pure money managers measure success by relative performance.  For wealth managers, like us, success is measured by our ability to deliver results consistent with our clients’ expectations.  The real strength of rebalancing is that you fair better through the market’s zigs and zags by staying invested.