Rebalancing Act – Why It MattersGlobal 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 FactorsPortfolio 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.
Endnotes1 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.
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