In the past several posts, I’ve been describing the benefits of achieving financial balance. All well and good, but if there’s one insight gained after 25 years in the business, it’s how quickly and frequently balance achieved can become balance lost – in life and your investment portfolio.
Fortunately, we’ve got rebalancing to help us roll with the inevitable punches. By helping our clients periodically rebalance their portfolios, we help them achieve a number of desirable goals. Rebalancing helps them:
- Avoid hyperactive trading while consistently buying low and selling high
- Avoid accidentally taking on more investment risk than planned for
- Remain on track toward long-term financial goals
- Make judicious decisions about how to invest new dollars, and withdraw existing ones
Portfolio Rebalancing: How It Works
When we create investment portfolios, we do so according to particular percentages defined in each client’s personalized Investment Policy Statement. As the markets shift, their investments tend to stray from their original, intended “weights” or allocations. Rebalancing is the act of shifting those allocations back where they belong – between the broad asset classes like stocks vs. bonds, as well as among the more granular asset classes such as small- versus large-company stocks, international versus domestic bonds, and so on.
To illustrate, imagine your portfolio is supposed to be half stocks and half bonds. When the stock market outperforms the bond market (as it is expected to do over the long haul), you end up with too many dollars in stocks relative to bonds. Of course the reverse can periodically happen as well. Either way, you go out of balance from your intended 50/50 mix. There are two ways we can rebalance:
- We can sell some of the now-overweight assets, and use the proceeds to buy assets that have become underrepresented, until your portfolio is back at or near its desired mix.
- As we’re adding to or removing from the portfolio as part of your greater investment and spending plans, we can buy underrepresented assets and/or sell overrepresented ones.
Did you catch what just happened? Not only are we keeping your portfolio on track toward your goals, but we’re naturally buying low and selling high. Better yet, the trades are not a matter of fancy guesswork or emotional whims. They’re accomplished according to your carefully crafted, customized plan.
Striking a Rebalancing Balance
Rebalancing as described is integral to helping you succeed as an investor. But like any powerful strategy, it should be used with care and understanding. Trading costs are among the biggest considerations. In theory, if trading were free, we could rebalance a portfolio every day with absolute precision. In reality, trading incurs fees and potential tax liabilities. This means it’s good to remain close to balance, but it may not be practical to remain spot on at all times.
To help us achieve a reasonable, middle ground, we have developed guidelines at The McClelland Financial Group. Specifically, we’ve adopted three “checkpoints” for determining when it’s time to rebalance, and when it may not be worth the trading costs involved. Rebalancing is triggered if any or all of these conditions exist:
- Whole balance – The total amount of imbalance across all of a portfolio’s asset classes should not exceed 15%. For example: If six asset classes are each off by more than 2.5 % (6 x 2.5% = 15%), this triggers a need to rebalance.
- Individual balance compared to the whole – No single asset class should be more than 20% off from its relative weight in the portfolio. For example: If you’re supposed to be holding 20% of your total portfolio as international stocks, we’d want to rebalance if that relative weight exceeded 24% or dropped under 16%.
- Individual balance compared to itself – No single asset class should be more than +/– 4 percentage points off from its ideal weight. For example: If you were supposed to have 30% in fixed income investments but you ended up with 25%, that equates to a 5-point difference (30% – 25% = 5 percentage points).
The Rebalancing Take-Home
Rebalancing makes a great deal of sense once you understand the basics: It gives you a clear, evidence-based process and cost-effective solutions for staying on course toward your personal goals through rocky markets. It ensures you are buying low and selling high along the way. What’s not to like about that?
At the same time, rebalancing within your globally diversified portfolio requires informed management to ensure it is being integrated consistently and cost effectively. Helping our clients periodically rebalance their portfolio when warranted is another vital way we seek to add value to their investment experience.