Strict rebalancing is a critical part of a disciplined investment strategy. In a given period, asset classes experience different performance results; this is both inevitable and desirable. As some assets appreciate in value and others lose value, your portfolio’s allocation changes, which affects its risk and return qualities. This is a condition known as asset class drift or style drift. If your original target allocation strays too far, you take on more or less risk than intended.
Graphic 12: Strict rebalancing
We rebalance our portfolios in terms of:
- Equities versus bonds.
- Domestic securities versus international.
- Asset allocation.
Rebalancing moves a portfolio back to its original target allocation by following the first rule of investing: buy low and sell high. By selling valuable assets and buying devalued ones, the portfolio is rebalanced back to its original allocations. We rebalance portfolios when any level differs from its target weight by 10% or more.
Systematic rebalancing overcomes the tendency to invest emotionally. Rebalancing might seem counter-intuitive, as most investors’ instincts are to buy what is going up and to sell what is going down, but it forces us to buy what is unfavourable.
There are four critical reasons why we would sell the winners:
- As illustrated in Graphic 9 (on the Managing Risk page), the random and unpredictable nature of asset class returns makes it likely that today’s winners will be tomorrow’s underperformers.
- Reducing risk is more important to your portfolio’s long-term growth than trying to achieve the highest possible short-term returns.
- The discipline of selling off winners to rebalance your allocations can significantly reduce portfolio volatility.
- Studies indicate that, by selling winners to rebalance your allocations, you can significantly reduce your portfolio’s volatility.8, 9, 10
Remember that you chose your original asset allocation to reflect your personal risk and return preferences for the long-term. Rebalancing structurally aligns your portfolio based on these priorities rather than recent performance decisions. It costs because there is a fee for every trade, but the long-term benefits far outweigh the price.
We structure a customized plan for each of our clients unique of goals, risk tolerance, cash flow, and tax status. No one knows where the capital markets will go exactly — however, we offer a well-defined, globally diversified strategy and manage your portfolio to meet your needs.
- Norbert M. Mindel, Wealth Management in the New Economy, (New York: John Wiley & Sons, Inc., 2010). 151.
- William J. Bernstein, “The Rebalancing Bonus, Theory and Practice,” 1996, www.efficientfrontier.com/ef/996/rebal.htm.
- Consulting Group, “The Art of Rebalancing: How to Tell When Your Portfolio Needs a Tune-up,” June 2005, www.asaecenter.org/files/ArtofRebalancing.pdf.