The Importance of Rebalancing Your Portfolio

Depending on whom you ask, as much as 20-33% of all equity investments is held in index funds. Index funds have always been popular, but the recent bull market has seen billions of dollars pumped into them by individual investors who view them as an easy and safe way to ride the wave and diversify equities. But, relying on index funds for a large portion of a portfolio overlooks one critical and often ignored process – rebalancing.

Portfolio rebalancing is part of the portfolio monitoring process. Portfolio monitoring is the continuous, ongoing assessment of a portfolio relative to the portfolio’s original intent or goal, changes in investor preferences, and changes in capital market conditions and expectations. Rebalancing or reallocation usually refers to bringing a portfolio back to its original state, assuming no change in an investor’s preferences or capital market expectations. 

For example, an investor may choose a mix of 60% stocks and 40% bonds in order to have a risk-adjusted expected return going forward. But if the stocks are all invested passively in index funds and the rising market produces returns that boost the stock percentage of the portfolio to 70%, the investor has adopted more risk than was their original intent. Rebalancing could involve selling 10% of the stocks in the portfolio in order to bring the overall percentage back to 60%, and reinvesting the funds in bonds.

In a year like last year when both Large-cap U.S stocks as measured by the S&P 500 and Developed Markets as measured by the MSCI EAFE Index were up over 20%, a portfolio that had 60% in stocks would have ended the year at a 72% weight in equities. Thus the equity portion of the portfolio would be 20% overweight vs its normal 60% target. Best practices would dictate that an investor rebalance back to the 60% target. 

What normally triggers a manager’s decision to rebalance a portfolio is usually not a single piece of information. It usually entails the receipt of small amounts of new information that eventually triggers a rebalance decision by the portfolio manager. The passage of time and the dynamics of the marketplace will inevitably impact a portfolio's original asset allocation. A resulting overweight of one asset group versus another occurs usually when one either significantly out or underperforms the other asset classes. Part of the decision process to rebalance involves a decision that this trend in under or outperformance has run its course.

By controlling risk and reallocating funds to parts of the markets that offer attractive returns that are still expected but have not yet occurred, future portfolio performance should benefit. A decision to shift or change a portfolio’s asset allocation is the most critical timing decision. The choice is usually at the level of fixed income, equities and cash and is primarily triggered by changes in capital market conditions that alter the expected return and risk relationships for one class of assets relative to another. 

The rebalancing decision becomes a little more murky when capital gains taxes are part of the equation. If you are dealing with a tax-deferred account such as an IRA where taxes are not an issue you can be much more diligent in applying a rebalancing strategy. However, when a portfolio is a taxable account and an investor has to pay capital gains, the decision to rebalance become a little tougher. At the end of the day it still is important to rebalance but maybe you do it over two tax years to spread the tax hit. Ideally, investors would have both a retirement account and a taxable account as part of their retirement assets to be able to move the combined portfolio to a rebalanced position.

Age and your time horizon for your investment portfolios all is an issue. The older we get the shorter time horizon our portfolios have. Rebalancing becomes more important the shorter time horizon a portfolio has. We have less time to recover from a deep bear market. This is especially true if you are relying on the portfolio for income to pay your monthly expenses.

Another event which can occur which would cause a rebalance is a large infusion of cash into or out of a portfolio. It is the portfolio manager’s job to decide whether a rebalance should occur immediately or over a period of time. If a client adds a significant amount of cash to a portfolio and the source of those funds was not the sale of an existing portfolio a manager may dollar cost average the funds into the market again if this was new money to invest in the markets. 

A Financial Analysts Journal article suggests that 93% of a portfolio's performance over time can be attributed to rebalancing. So, while investors have done well riding the bull market and taking advantage of passive investments like index funds, it is always prudent to consider risk tolerance and timing as part of an investment strategy. Rebalancing is a necessary process in addressing these and is best done by a qualified investment professional.

Source:

Financial Analysts Journal; May/Jun 1991; 47, 3; ABI/INFORM Global pg. 40