Asset allocation is well known as a foundation for responsible investing, but many investors fail to realize that once they’ve chosen their asset allocations, they must continue to rebalance periodically to risk-manage their portfolios and ensure growth.
Prevent Drift in Your Portfolio’s Risk/Return Profile
The most common use of rebalancing is to prevent a drift in your portfolio’s risk/return profile.
Setting up your initial asset allocation is just the start because, over time, your portfolio will become unbalanced as some asset classes grow faster than others. “Safer” investments, such as fixed income, exhibit different growth rates than “riskier” assets such as stocks.
As a result, the actual allocation between “safer” and “riskier” assets will change over time. This will cause a portfolio’s risk/return profile to drift substantially from your target allocation, making it become more risky or less risky than desired.
You should rebalance when your portfolio gets too far away from your target allocation – whenever your allocation is over two percent away from your target percentage.
Making the Most of Volatility
Rebalancing works in conjunction with asset allocation to decrease portfolio volatility without sacrificing return. First, asset allocation is used to select volatile assets that offset or mitigate each other’s risk and to determine optimal target weights for different classes of investments. Next, rebalancing between these assets is the mechanism by which the magic of holding these diversified assets is unleashed.
The result? A portfolio that has higher returns, with far less volatility.
Opportunities for this type of rebalancing, also known as volatility pumping, can be fleeting. Therefore, it is critical for your financial advisor to review your portfolio frequently and execute quickly when opportunities arise.
The effect created within your portfolio as a result of this kind of rebalancing can be compared to the pistons in a finely tuned engine. The further your pistons travel, the more powerful your engine. Similarly, the more volatile your assets, the more mileage you get from rebalancing.
Trim Your Winners, Add to Your Losers
Rebalancing forces you to periodically trim back your winners and add to your losers to keep your allocations on target.
But is it really wise to invest more money in “losing” asset classes, and less in the “winners”? That depends on your assumptions about the future direction of these asset classes. If you believe that a decline is temporary, then investing additional money to bring the allocation back up to target allows you to benefit more when it eventually recovers.
It’s counterintuitive, but it works because it imposes a discipline on yourself to systematically buy low and sell high, over and over again.
At the same time, by taking some of the winnings off the table with your better-performing assets, you are not getting hurt as badly when the assets decline.
There is an important caveat to rebalancing. If you believe that the decrease is the beginning of a protracted decline in that asset class, then you may need to update your original asset allocation. And then it’s back to the drawing board…
Between helping your portfolio maintain a stable risk level and extracting the benefit from owning diversified assets, rebalancing is a key component to disciplined investing.
Marina Goodman, CFP®, is an investment strategist at Brinton Eaton, a national fee-only wealth advisory firm based in Madison, N.J.