Thoughts on Portfolio Rebalancing

On 06/24/2011, in Investment Strategies, by Jordan Wilson

The goal of portfolio rebalancing is to bring your actual asset allocation back in line with your target allocation.

Your target allocation should be based on your Investment Policy Statement (IPS). This reflects your personal circumstances, investment objectives, constraints, risk tolerance, etc.

Who you are as an investor. 

When initiating your investment strategy, it is pretty simple to adhere to the target asset allocation. But over time, as certain assets perform well and others lag, your actual allocation will deviate from your target.

Additionally, as your personal situation changes, you may need to adjust your target asset allocation.

In either of these cases, you will need to rebalance your portfolio.

Today, a few thoughts on rebalancing in general.

Buy and Hold?

How can you buy and hold, yet rebalance? Is that not a contradiction?

To some extent, yes.

The longer you hold an asset, the less transaction costs you incur and the longer you defer paying tax on capital gains. Minimizing and delaying costs improves compound returns for your portfolio.

As well, selling an asset and reinvesting the proceeds in another investment may not guarantee improved results. Attempting to time markets or the peaks and valleys of individual assets may not achieve better performance.

So you want to try and hold your assets as long as is prudent.

But sometimes you will need to adjust your assets. Either to fix your asset allocation. Or possibly to sell poor investments.

Dump the Dogs

Hopefully you will not have too many under-performing investments that should be sold.

If you follow my investment strategy, you should not have many (any?) dogs.

There are two reasons for this.

One, I generally recommend investing in an asset class, or sub-class, as a whole. I tend not to recommend investing in individual, non-diversified assets.

If you wish to invest in Canadian equities an index mutual or exchange traded fund with broad exposure to the Canadian market should be your choice.

By investing in a diversified portfolio with multiple holdings that perform in line with a broad market, you should not have any individual under-performers.

Two, by conducting proper due diligence before investing your wealth in funds, you should acquire “best of breed” investments.

That should minimize problems with items such as tracking error and fund expenses which can impair net performance.

Of course, over time fund management and relative performance can change. So you need to always be sure that your investments rank in the top quartile (or better) of their category.

Now if you invest in non-diversified assets (e.g., individual equities or bonds) or actively managed funds, there is a higher probability that some of these investments will under-perform. At a future date, we will look at assessing non-diversified assets.

Minimize Costs

Each time you sell an asset, you incur costs.

Transaction costs on the sale and subsequent reinvestment in another asset.

Capital gains that are triggered on sales. By delaying divestment, you defer the potential tax liability.

Possible opportunity costs as well. For example, it is extremely difficult to time market or asset movements. If you divest an investment, perhaps its performance will improve and you will have missed out on the gains.

These costs negatively impact the ability to maximize your portfolio’s compound returns. So use care when selling investments to rebalance.

Use Ranges to Rebalancing

I suggest using ranges to rebalance.

For example, if your target equity allocation is 50%, do not rebalance unless your actual allocation is greater than 60% or less than 40%.

Using a range provides some flexibility for portfolio volatility.

If your target allocation is 50% equities and you rebalance at 55%, you may find that the change was due simply to general market volatility and not a long-term change, If this is the case, you may see your actual equity level fall back to 45% the following year and you may need to rebalance up again.

By using a range linked to the risk of the asset, it may reduce your rebalancing needs and related costs.

Frequency of Rebalancing

Always a tough question as to how often a portfolio should be rebalanced.

Rebalancing should be the result of the portfolio review process.

Portfolios should be reviewed a minimum of once per year. For a portfolio with higher risk, there should be a greater number of reviews each year.

If your review process indicates that you need to make changes, then do so.

But make sure that your rebalancing ranges are adequate so that you are not constantly selling investments and purchasing new ones.

It is hard to pick a firm number as there are so many variables that impact a need to rebalance. But if you are adjusting your portfolio more than once a year (assuming you are primarily invested in index funds), you may want to consider the reasons why.

Next up, we will look at ways to rebalance one’s portfolio on a cost-effective basis.


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