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Rebalancing Act – Why It Matters

Global diversification gives investors a valuable tool for managing risk and volatility in a portfolio. But smart diversification has an important side effect. It requires maintenance. In a given period, asset classes experience divergent performance. This is inevitable and, in fact, desirable. A portfolio that holds assets that do not perform similarly (i.e., with low return correlation) will experience less overall volatility. That results in a smoother ride over time. However, dissimilar performance also changes the integrity of your asset mix, or allocation—a condition known as “asset drift.” As some assets appreciate in value and others lose value, your portfolio’s allocation changes, thereby affecting its risk and return qualities. If the allocation drifts far enough away from your original target, you end up with a different portfolio. That’s why, at True North Capital Alliance, we advocate analyzing and rebalancing our clients’ portfolios periodically. Once we design and construct your portfolio to match your current investment goals and risk tolerance, we monitor performance to preserve the portfolio’s structural integrity because asset allocation accounts for most of a portfolio’s return.1 To efficiently pursue your investment goals, we must manage asset drift. Rebalancing is the remedy. In general terms, rebalancing involves selling assets that have risen in value and buying more assets that have dropped in value. The purpose of rebalancing is to move a portfolio back to its original target allocation. This restores strategic structure in the portfolio and puts you back on track to pursue long-term goals.

Why rebalance?

At first glance, rebalancing seems counter-productive. Why sell a portion of outperforming asset groups and acquire a larger share of underperforming ones? Intuition might suggest that selling previous winners may hinder returns in the future. This logic is flawed, however, since past performance may not continue in the future, and there’s no reliable way to predict future returns. Equally important, remember that your original asset allocation was selected because it reflected your risk-return priorities. Rebalancing realigns your portfolio to these priorities by using structure, not recent performance, to drive investment decisions. Periodic rebalancing also encourages dispassionate decision-making, which is an essential quality during times of market volatility. Moreover, if and when your overall financial goals or risk tolerance changes, we have a foundation for making adjustments. In the absence of a plan, adjustments are a matter of guesswork.

Challenges and Decision Factors

Portfolio allocations are usually complex, incorporating not only fixed income and equity, but also multiple asset groups within equity investing. The more complex a portfolio’s allocation, the greater is the need for maintenance. Determining when and how to effectively rebalance requires careful monitoring of performance and awareness of your tax status, cash flow, financial goals, and risk tolerance. Rebalancing also incurs transaction fees and potential capital gains in taxable accounts. Thus, while there are good reasons to rebalance, we firmly believe that we should only rebalance when the benefits outweigh the costs. Given these challenges, we prefer to take a practical rebalancing approach using asset drift triggering points while leaving enough flexibility to manage costs effectively.  Defining triggering points helps us decide when to rebalance. Most experts recommend rebalancing when asset group weightings move outside a specified range of their target allocations. This may be widely defined according to stock-bond mix, or more appropriately, according to a percentage drift away from target weightings for categories like small cap stocks, international stocks, and the like. While rebalancing costs are unavoidable, several strategies can help minimize the impact:
  •  Rebalance with new cash. Rather than selling over-weighted assets that have appreciated, we prefer to use new cash to buy more under-weighted assets. This reduces transaction costs and the tax consequences of selling assets.
  • Whenever possible, we look for ways to rebalance in the tax-deferred or tax-exempt accounts where capital gains are not realized.
  • Incorporate tax management within taxable accounts, such as cost basis management, strategic loss harvesting, dividend management, gain/loss matching, and similar considerations.
  • Implement an integrated portfolio strategy. Rather than maintaining rigid barriers between component asset classes and accounts, we prefer to manage the portfolio as a whole.
Rebalancing incurs real costs that can detract from returns. Therefore we define ranges within which investment components can acceptably drift and adopt cost-saving strategies during rebalancing, paying particular attention to tax-sensitive transactions. In helping our clients rebalance, we strive to develop a structured plan that remains flexible to each individual’s unique blend of goals, risk tolerances, cash flow, and tax status. No one knows where the capital markets will go—and that’s the point. In an uncertain world, investors should have a well-defined, globally diversified strategy, which their portfolios are managed to implement over time. Rebalancing is a crucial tool in this effort.

Endnotes

1 Gilbert L. Beebower, Gary P. Brinson, and L. Randolph Hood, “Determinants of Portfolio Performance,” Financial Analysts Journal 42, no. 4 (July/August 1986): 15-29. Gilbert L. Beebower, Gary P. Brinson, and Brian D. Singer, “Determinants of Portfolio Performance II: An Update,” Financial Analysts Journal 47, no. 3 (May/June 1991): 40.                     Continue Reading No Comments

Recommended Reading List

Bernstein, William (2001).  The Intelligent Asset Allocator. New York:  McGraw-Hill.

 An in-depth look at asset allocation in passive and index portfolios.  Bernstein makes a case that having a coherent asset allocation strategy is the key to long-term success in investing.  A practicing neurologist, Bernstein uses his self-taught investment knowledge and research to teach independent investors how to build diversified portfolios.

Bogle, John C. (2007). The Little Book of Common Sense Investing. Hoboken, New Jersey:  John Wiley & Sons.

A thorough examination of the benefits of index and passive investing written by the founder and former CEO of the Vanguard Group and creator of the world’s first index mutual fund.  Bogle believes that investing is all about common sense and that owning a diversified portfolio of stock and holding it for the long-term in a winner’s game.

Lowenstein, Louis (2008). The Investor’s Dilemma:  How Mutual Funds are Betraying Your Trust and What to Do About It. 

Based on cutting-edge research by leading corporate critic Louis Lowenstein, The Investor’s Dilemma shines a harsh light on much of what is wrong with the mutual fund industry; it also outlines a value-oriented approach to this market that will allow individual investors to achieve investment success.

Malkiel, Burton G. (2011). A Random Walk Down Wall Street. New York:  W. W. Norton & Company.

A Random Walk is a classic guide for the individual investor who wants insight into how markets really work.  Malkiel covers the full range of investment opportunities and advances the premise that individual investors are better off buying and holding index funds than pursuing securities or actively managing mutual funds. Written for the financial layperson but bolstered by 30 years of research, A Random Walk, which is in its seventh printing, presents a thorough explanation of the benefits of passive investing.

Swedroe, Larry E (1998). The Only Guide to a Winning Investment Strategy You’ll Ever Need.  New York: Dutton.

Swedroe provides an easy-to-read and informative introduction to passive investing and DFA-style allocation models. He describes the crucial difference between “active” and “passive” mutual funds and explains how investors can win the investment game through long-term investments in such indexes as the S&P 500 instead of through the active buying and selling of stocks.

Swedroe, Larry E (2001). What Wall Street Doesn’t Want You to Know.  New York: St. Martin’s Press.

An easy-to-read introduction to passive investing.  Swedroe gives the reader the “inside information” needed to understand the pitfalls of trying to pick stocks and time the market. He explains why active managers rarely add value to your portfolio over time and how index and passive investing can be advantageous.

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Advisory services are provided through True North Global Research, Inc., d/b/a True North Capital Alliance, a Minnesota Registered Investment Advisor, with notice filing in Texas


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