Most investors have a basic understanding that their portfolios include a variety of securities types (stocks, bonds, mutual funds, ETFs) across a variety of industries and company types. Most also understand that their portfolio holdings carry different levels of risk and reward all designed to get you where you need to go financially in the most risk-appropriate way possible. Many know that this is all part of asset allocation and start investing with this in mind. But it’s one thing to set up a portfolio with an asset allocation strategy and quite another thing to stick to it.
That’s where portfolio rebalancing comes in. Rebalancing is the gentle art of buying or selling within the portfolio or adjusting contribution approaches so that a portfolio keeps the correct proportions of investment types to fulfill an investor’s financial goals, life stage, and risk tolerance.
Many advisors recommend portfolio rebalancing either periodically (at least once during a regular time period, like every six or twelve months) or rebalancing when portfolio allocations “drift” due to the market. For instance, say you’re an investor whose portfolio is supposed to consist of 60% stocks and a 40% mix of bonds and cash. But a bull run on stocks means your stock holdings have drifted up to 70% of your portfolio. Then it’s time to rebalance back to the original 60%-40% split.
Rubber of risk tolerance hits the road
In theory, portfolio rebalancing isn’t that complicated. But in reality, making subtle rebalancing adjustments is where the rubber of risk tolerance hits the road—and it’s a practice best done with a financial advisor’s help, since advisors may have more objectivity about the market and can remind clients when a healthy adjustment makes more sense than irrational enthusiasm or fear, given an investor’s goals.
On the one hand, investors shouldn’t “day trade” within their retirement accounts every time there’s a hiccup in the market. But they shouldn’t completely ignore opportunities to adjust their retirement portfolio—as long as they adjust on what the Securities and Exchange Commission calls a “relatively infrequent” basis. After all, retirement portfolios are meant to shift and grow over decades, not single quarters or market phases.
“We recommend investors rebalance at a minimum once a year,” says John Flavin, a CFP with Synergy Financial in Seattle. “You need to let the cake you’ve mixed bake in the oven. If you keep opening the oven door, will it bake?”
Many investors are “aggressive” when the market is hot, willing to invest in and hold risky stocks or sector funds in industries experiencing growth—even if their portfolios drift into inappropriately risky territory. It’s enjoyable to watch assets increase. But these same investors are suddenly “conservative” when the market cools off, wanting to move out of these investments rather than watch a downward correction in the stock or Net Asset Value (NAV) price of a particular type of asset that, over the long haul, will have another uptick.
Some investors like to buy low, but they conveniently forget to “sell high”—to their detriment, notes Flavin. “Remember the dot-com boom? During the late 1990s, no one wanted to rebalance away from tech startups. Thank goodness we did some rebalancing for our clients.”
The SEC puts it this way in its primer on portfolio rebalancing: “Shifting money away from an asset category when it is doing well in favor of an asset category that is doing poorly may not be easy, but it can be a wise move. By cutting back on the current ‘winners’ and adding more of the current so-called ‘losers,’ rebalancing forces you to buy low and sell high.”
More than one way to rebalance
There’s no one-size-fits-all method for rebalancing. Indeed, sometimes an investor’s personal situation forces a portfolio rethink, says Flavin. This is not so much a rebalance as a one-time adjustment related to an outside circumstance. In his practice, he’s seen people adjust portfolios due to changing job circumstances (risk of job loss, for instance) or due to an unusual uptick in income—for instance, an investor with $1 million set aside who suddenly has $100,000 to add to the mix.
Vanguard Group, the mutual fund company, in November 2015 published research indicating that a “time plus threshold” approach may work best for investors. If investors rebalance consistently over a regular time period (quarterly, semi-annually, annually) and only make changes when assets have drifted beyond a 5% threshold from the original allocation, that may make the most sense.
When it comes to the actual buying and selling of assets in a rebalance, you can rebalance by selling off “over-weighted” asset classes – that is asset classes that represent a disproportionate share of your portfolio relative to a benchmark – and buying up “under-weighted” asset classes – those which represent a lower share versus the benchmarks. You can purchase new types of assets in under-weighted asset categories; or you can adjust your regular contributions to add more weight to some investment types while reducing investment in others.
“You don’t have to go back to the exact percentages of yesteryear,” notes Mr. Flavin. “All of our portfolio strategies have an acceptable range of asset class allocations. If you’re working with an advisor, you may need to ratchet back but not all the way. For instance, if we’d recommend a maximum of 25% allocated to large-cap equities and your portfolio has drifted to 55%, we might bring it down to 30% in certain circumstances.”
In other words, with financial advisor oversight, this investor might enjoy some growth as might happen at the launch of a bull run, but not drift to the deep end of the pool in terms of risk. The point, Mr. Flavin says, and Vanguard research suggests, is to work with a strategy consistently over time.