Rebalancing 101

By Guest Blogger Ryan Lewenza

A common theme on this blog is the importance of balance in portfolios. I’m going to get wild and crazy today and discuss the importance of (re)balancing portfolios. Hey what I can say, I live on the edge!

What is it?

As markets gyrate and change over time this impacts a portfolio’s asset mix (the percentage in stocks and bonds), putting things out of whack. For example, using our preferred 60/40 balanced portfolio, if stocks have a great year and outperform bonds, the percentage weight of stocks within the overall portfolio will increase while the weight in bonds will decline. After a strong year in the equity markets the equity weight could increase to 65%, with fixed income representing 35% of the overall portfolio. Rebalancing entails just getting the asset mix back in-line with the preferred 60/40 weights, so this would involve selling 5% of the equities and adding 5% to fixed income.

Why do it?

There are three key reasons to do this. First and foremost is to help to control risk in the portfolio. If equities have a great run and, as a result, then make up 70-80% of the portfolio, this results in a much higher risk level than the preferred 60/40 asset mix. Second, it imposes a level of investment discipline, which is so critical to successful long-term investing. Essentially, systematically rebalancing forces you to trim your winners and add to underperforming assets. You’ve probably heard the old market adage “buy low, sell high”, well, rebalancing is this in a nutshell. Lastly, a disciplined rebalancing strategy improves investment results.

Below is a table that shows the benefits of rebalancing portfolios, both from a return and risk perspective. Rebalancing a portfolio annually helps to reduce risk (standard deviation or portfolio volatility) and increase returns. Lower risk and higher returns is basically a free lunch and in the investing world there are very few of those.

Rebalancing Pays Off

Source: SCIR, Turner Investments

When to do it?

We basically use two different methods in determining when to rebalance portfolios – a fixed time schedule or a portfolio change driven event. In annual portfolio reviews with clients we review the asset mix (among many other things) and if the asset mix has deviated too far from our 60/40, we’ll rebalance the portfolio back to this asset mix. Or, if due to any major market moves, a particular asset class has gone above a certain threshold range, then we’ll look to rebalance portfolios. For example, if the US equity markets go for a major rip and the US equity weight increases to 25% (from our 20% recommended weight), we’ll trim back US equities and add that 5% to an equity market or asset class that has underperformed.

Costs of rebalancing

There are a few drawbacks to rebalancing. First are transaction costs. Rebalancing requires trades, which results in a cost. For fee-based accounts there are no additional costs to clients, one more reason why we prefer fee-based accounts to commission-based accounts. The second consideration is taxes. Rebalancing entails trimming your winners, which often results in a capital gain and taxes owing? From our perspective, we always view capital gains and taxes on the gain as a secondary consideration (our market call and portfolio positioning being the main driver), but taxes should still be considered when making changes. Sometimes, if we’ve generated significant gains for a client in a particular year and we want to rebalance an account later in the year, we’ll push out the rebalancing into the next year so as to smooth out and minimize the tax impact. It’s good to have general guidelines but be flexible!

Finally, from an investment performance standpoint, rebalancing a portfolio can sometimes limit the upside, particularly in a raging bull market. In this circumstance you’re trimming the equity weight while the equity markets continue to surge higher. But don’t forget that rebalancing is as much about controlling risk as it is about maximizing returns and, more often than not, it’s prudent and wise to trim your winners along the way as no trends last forever. As I like to say, “no one goes broke by taking a profit”.

So there’s the 101 on rebalancing. With the New Year we’re busy talking with clients and reviewing portfolios, with rebalancing being an important component of our client reviews. Following the market weakness in Q4 we’re rebalancing portfolios by adding to our preferred share and equity holdings. Maybe now’s the time to review your portfolio and do the same.

Ryan Lewenza, CFA, CMT is a Partner and Portfolio Manager with Turner Investments, and a Senior Vice President, Private Client Group, of Raymond James Ltd.