Investment management is one of the key services we provide to our clients. Investments are the engine that provides the money to help clients meet their financial goals such as enjoying a comfortable retirement and funding a college education for their children.
Our client portfolios are built with our client’s goals, their time horizon for the money and their risk tolerance in mind. Asset allocation is a key tool in helping us develop a portfolio that meets these criteria. Allocating the appropriate percentages to stocks, bonds and cash is a start. We go beyond this, to look at asset allocation at a more granular level to include sub-asset classes such as domestic large cap, small cap and mid-cap stocks. We balance the allocation at appropriate levels between growth and value-oriented stocks, as well as including non-U.S. stocks. We perform the same level of analysis when it comes to fixed income and cash-like assets.
Coming up with the right asset allocation is a start. Markets move higher and lower, specific asset classes will perform differently over time. It’s a virtual certainty that your portfolio will deviate from its target asset allocation over time. Foreign stocks may lead the way one quarter, domestic large value stocks another quarter.
Assuming the target asset allocation we’ve come up with for a client is still the best one for them, periodic portfolio rebalancing is critical to maintain that target allocation.
What is portfolio rebalancing?
Portfolio rebalancing is the realigning of the investment assets back to the target asset allocation for the portfolio.
Using a very simplistic example, let’s say a portfolio has a target allocation of:
- Stocks 60%
- Bonds 35%
- Cash 5%
If the stock market has a solid run upwards, that allocation might look like this:
- Stocks 75%
- Bonds 22%
- Cash 3%
In this situation the allocation to stocks is much higher than the target allocation. This could result in your portfolio being exposed to more downside risk than you are comfortable with should the stock market head down.
Portfolio rebalancing would involve taking steps to bring the allocation back in line with the target allocation.
How does portfolio rebalancing work?
At its most basic level, portfolio rebalancing involves buying and selling securities within the portfolio in amounts that will bring the asset allocation back to target levels. Securities in asset classes that are overweight compared to their target allocation are sold, with the proceeds of these sales allocated to securities in asset classes that are underweighted compared to their target allocation.
This is a process where you will want to be conscious of where these investments are held. Buying and selling inside of the 401(k), IRA or other type of retirement account won’t have any tax consequences.
Transactions inside of a taxable brokerage account generally will have tax implications either on capital gains from the sale or capital losses.
Beyond simply buying and selling securities within the portfolio, additional investments can be used as part of the rebalancing process where applicable. For clients who are contributing to a 401(k) or similar workplace retirement account on a regular basis, they can redirect their ongoing contributions to investment options in asset classes that are underweighted.
Likewise any contributions of new money to an IRA or a taxable brokerage account can also be directed to investments in underweight asset classes. Similar to the investment of new funds, portfolio cash flows can be used as part of the rebalancing process.
Portfolio cash flows might include dividends from shares of individual stocks or distributions from mutual funds and ETFs. Instead of having this money reinvested back into the security that generated the distribution, you can let this money accrue in a money market fund or similar vehicle, then direct it towards holdings in asset classes that might be a bit underweight.
Rebalancing instills discipline
Reviewing portfolios for potential rebalancing at regular intervals instills a level of discipline on investors. If you set an interval such as quarterly or semi-annually to review your portfolio the discipline inherent in performing these portfolio reviews is helpful in and of itself.
A big part of this discipline is the commitment to periodically selling some of the winning positions inside of your portfolio and using that money to reinvest back into areas that have lagged a bit. We all celebrate our wins and our gains in the market so it might seem counterintuitive to sell positions in securities that have enjoyed solid gains. But this is the whole point of asset allocation as a means to control your downside risk.
Ideally an investor will have a number of criteria that are used in reviewing and monitoring their investments. Many financial advisors and investors include these criteria in a document called an investment policy statement (IPS). An IPS will often include:
- A specified timetable to review their individual holdings relative to an appropriate benchmark.
- A blended benchmark against which you can track the performance of your portfolio. A blended benchmark might consist of a blend of several appropriate stock and bond indexes based on the percentage of the asset class they are tied to in your target asset allocation.
- Rules regarding the concentration of holdings in terms of a particular security or an asset class. Concentrated holdings in an individual stock can sometimes add even more risk to a portfolio than an over allocation to an asset class. In the case of an individual stock holding a change in the company in terms of their market share, financial performance or other factors can lead to significant decline in the share price. If this stock represents a significant portion of your overall portfolio, the risk is magnified.
The commitment to review your portfolio for rebalancing at regular intervals is a key factor that can contribute to the success of your investment strategy. Whether you have a formal planning document like an IPS, or your target asset allocation is included in other financial planning materials that you or an advisor have created, it’s important to have criteria and a regular timeframe which you use to review your portfolio for potential rebalancing.
You are not smarter than the markets
A key point to remember regarding portfolio rebalancing is that investors are not smarter than the stock market. What we mean is that investors have tried to time movements in the markets seemingly forever. While some might be able to do this over a short period of time, few if any investors have been able to do this on a consistent basis.
Investors who let winners continue to run without rebalancing if needed run the risk of allowing their portfolio’s asset allocation to be skewed too far towards equities. This can potentially expose them to more risk than they are comfortable taking. Their rationale might be something like “it’s different this time” or “this stock has a ton of upside.”
Sometimes these investors are right for a while, but over time the risk they are incurring by letting their allocation to equities stray too far from their target becomes great. And when the inevitable market decline hits, their portfolio declines far more than their target asset allocation might have indicated.
Here are some things we take into account regarding rebalancing for our client’s portfolios.
Target asset allocation
A client’s asset allocation is an outgrowth of their overall financial plan. It is at the core the investment strategy used to help them achieve their various financial goals outlined in their financial plan.
Rebalancing means bringing the portfolio’s asset allocation back in line with its target allocation. Like many advisors, we implement rebalancing when one or more of the asset classes in our client’s portfolio exceeds a certain percentage deviation from the target allocation. A typical rebalancing threshold might be when the actual asset allocation strays more than +/- 5% or 10% from the target allocation.
Rebalancing time frames
Portfolios should be reviewed for potential rebalancing at regular time intervals. These time intervals should not be too frequent, however. It can be detrimental to rebalance too frequently based on extremely short-term price movements in the markets.
Generally we suggest quarterly, semi-annually or in some cases annually. We may suggest an interim portfolio rebalancing if the markets make an extreme move up or down.
Total portfolio view
Investors should take an overall portfolio view for their asset allocation and portfolio rebalancing. This is especially important for investors who have several different investment and retirement accounts.
While the target asset allocation for some accounts might differ a bit, how this all rolls up at the portfolio level is key. For example you might invest a bit more aggressively in a 401(k) account that won’t be tapped for a number of years until retirement. You might balance the aggressive allocation in this account with a slightly less aggressive allocation in another account, perhaps a taxable account.
Taking a total portfolio view can also help you do your rebalancing in the most tax-efficient fashion possible. Sales of holdings made in a traditional or Roth retirement account will not incur any capital gains where they would if sold in a taxable account. Likewise realizing capital losses in a taxable account could provide a benefit at tax time while a similar loss realized in a retirement account would not.
Use autopilot when practical
For some accounts you may be able to put your rebalancing on auto pilot. By this we mean that you set the account to rebalance your holdings back to your target asset allocation for that account at set time intervals. This might be quarterly, semi-annually or at some other interval.
This is a common feature on many 401(k) platforms. This can be very convenient and ensures that the account is rebalanced periodically. This can be especially important if your 401(k) represents a significant portion of your overall portfolio.
If you do use auto-rebalance on any of your accounts be sure to factor this in when reviewing your overall portfolio.
Like many financial advisors, we suggest that investment considerations, not tax issues, drive your investing and rebalancing strategies. That said, rebalancing can offer some tax planning opportunities.
In the course of rebalancing involving a taxable account, you may need to sell some holdings that either have embedded capital gains or losses. In the case of positions where you would realize a loss, these losses can be used to offset capital gains from other sales, normal capital gains distributions that might be received during the year from mutual funds or against other income up to a limit of $3,000 per year. Any excess capital losses can be carried over to future tax years.
Rebalancing and charitable contributions
As part of the rebalancing process, you might find holdings in taxable accounts that have appreciated by a considerable amount. For those who are charitably inclined, it might make sense to designate a portion of these holdings for donation to the charitable organization of your choice rather than selling that portion.
This will still help reduce your overweight position in the stock, mutual fund, ETF or other security. The market value of the shares on the date of the donation to the organization will be the amount of your charitable contribution. For some who might otherwise not reach the threshold where they can itemize deductions, this can help.
An additional benefit is that you will never pay any capital gains taxes on this transaction. For some investors the combination of no capital gains taxes and the charitable deduction can be a powerful combination in their overall financial and tax planning strategies.
Investing has never been a one-time, set it and forget it decision. Periodic rebalancing back to your portfolio’s target asset allocation is a key tool in maintaining the proper balance between potential downside risk and growth over time.
Portfolio rebalancing is an important discipline for investors to adopt and maintain. Whether or not you actually do rebalance at any point in time is less important than the process of reviewing your portfolio for possible rebalancing on a regular basis. We’ve found this to be a key risk management tool for our client’s portfolios.
Please give us a call if you have any questions about rebalancing your portfolio or any aspect of investing, we are here to help.