Portfolio Rebalancing

The foundation of your investment plan is a strategic asset allocation which specifies what percentage of your portfolio will be allocated among different asset classes, such as stocks, bonds and cash. In choosing the appropriate allocation (for example, 50% stocks, 40% bonds and 10% cash) you must balance risk and expected return in a manner which takes into account your risk tolerance, investing time horizon and financial goals. Over time, as markets fluctuate, the asset classes in your portfolio will grow at different rates resulting in changes to your portfolio’s asset allocation. These changes, known as allocation drift, could result in a new or different risk and return relationship that may be inconsistent with your goals and preferences. In some years, stocks will grow faster than bonds, and, in other years we might see the opposite. What rebalancing does is return your portfolio to its true or target asset allocation. The primary goal of any rebalancing strategy should be to minimize risk relative to a target asset allocation, rather than to maximize returns.

There are four different types of rebalancing strategies, including Periodic, Range, Periodic and Range, and Cash Flow. The Periodic strategy is a time only strategy in which the portfolio is rebalanced every month, quarter or year, regardless of how much or how little the portfolio’s asset allocation has drifted from its target. The second strategy, Range, eliminates the time aspect of rebalancing and focuses on the amount of drift (say 3%, 5% or 10%) from the target asset allocation. The smaller the range (or amount of drift), the more frequent the rebalancing, which could be as often as daily. With larger ranges, rebalancing could occur less frequently or even never. Periodic and Range calls for rebalancing the portfolio on a scheduled basis, but only if the portfolio’s asset allocation has drifted from its target asset allocation by a predetermined range. If, as of the scheduled rebalance date, the portfolio’s drift is less than the predetermined range, the portfolio would not be rebalanced. Likewise, if the drift is greater than the predetermined range at an intermediate time interval, the portfolio would not be rebalanced. We employ the Periodic (annual) and Range (5%) rebalancing strategy on our client portfolios, a strategy which is rooted in the belief that rebalancing too often unnecessarily increases portfolio transaction costs and reduces returns as strong performers are not allowed to run.

History teaches us that the benefits of rebalancing over the long term outweigh the costs and that there is no proven or optimal period or range that must be selected for a successful rebalancing strategy. The primary benefit to be gained is that a rebalanced portfolio more closely aligns with the characteristics of the target asset allocation than does a portfolio that is never rebalanced. Transaction costs, in the form of brokerage commissions, sales loads and redemption fees, can be significant if the period or range is too small. When taxable accounts are rebalanced, capital gains taxes are due upon the sale of any appreciated asset. Some investors also feel the weight of the emotional cost associated with selling a winning stock so that they can add to the positions of losing ones. The fourth rebalancing strategy, Cash Flow, uses cash flows (dividends and interest, realized capital gains and new contributions) to purchase assets in underweighted asset classes. This strategy (which some experts say is not rebalancing at all) allows investors to manage risk and reduce the costs of rebalancing, as no asset sales are required.

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