Broker Check

Past Few Years Reinforce Advantages of Rebalancing Portfolio

by Howard Hook, CFP®, CPA

As published in The Princeton Packet, November 26, 2012

A costly mistake made by many people is based in the belief that a “buy-and-hold” portfolio is also a “set it and forget it” strategy. Nothing could be further from the truth.

Investing in mutual funds -- as opposed to individual stocks and bonds -- helps mitigate the need to check on a portfolio too frequently. Investors can achieve greater diversification by using mutual funds than they can by owning individual stocks and bonds. Still, portfolios should be reviewed at least quarterly.

A good portfolio review includes an examination of returns on individual investments against comparable benchmarks. Investments that have underperformed versus their benchmark may need to be looked at in more detail to ascertain what caused them to lag. Consistent under performance may justify replacing that investment. Be cautious when replacing investments due to short-term problems, though. There are many good investments, and in particular mutual funds, that can under perform their benchmark in the short term but still warrant remaining in your portfolio.

Another area to review is changes in fund management and investment style. These may be difficult to analyze for the non-professional investor, but are important to consider. There are websites available to help investors find information about key aspects of fund management.

One of the most important things investors should review within their portfolios is their overall asset allocation, meaning what percentage of assets are invested in the stock market versus fixed income and cash. Asset allocation that has strayed far from one's original intentions poses a much greater risk than one where the portfolio is rebalanced back to the investor's original allocation. This is often overlooked by many people when reviewing their investments.

It is therefore prudent to review asset allocation quarterly and rebalance the portfolio back to its intended allocation. Doing so ensures the risk tolerance of the portfolio is consistent with what the investor originally intended it to be.

Rebalancing is hard for some people because it feels counter intuitive. Why sell the investments that have performed well and buy investments that have not done as well?

The good news about rebalancing the portfolio back to its target allocation is that by doing so investors are automatically buying low and selling high. For example, an investment portfolio with a target allocation of 50 percent stocks and 50 percent bonds may be 60 percent stocks and 40 percent bonds following a strong bull market. Rebalancing the portfolio back to 50 percent stocks would involve reducing the stock position by 10 percent and increasing the bond position by 10 percent. Since the excess 10 percent stock position was caused by an increase in the price of the stocks, profits are being sold and reinvested into the bond portfolio.

Studies have shown that rebalancing a portfolio can result in better long-term returns than those that are not rebalanced. An even more important reason to rebalance, however, is to control the level of risk. Clearly, a portfolio with 60 percent invested in stocks is riskier than one with only 50 percent in stocks. Rebalancing back to 50 percent keeps the risk of the portfolio constant.

How often to rebalance is another question. Since rebalancing involves buying and selling investments, transaction costs and potential taxes must be considered.

Transaction costs. The use of a discount broker can help reduce transaction costs as they usually charge a nominal fee or no fee at all for mutual fund transactions. Also worth noting is that many mutual funds charge short-term trading fees for funds sold within 90 days of purchase. This is yet another reason to rebalance quarterly, as this schedule will help avoid short-term trading fees.

Capital Gains Tax. Tax costs are a consideration, especially in light of anticipated tax increases. However, remember that allowing too much risk to creep into a portfolio presents a far greater threat than paying income tax on rebalanced assets.

Many investors who rebalance their portfolio set thresholds which need to be met prior to rebalancing. Doing so can help reduce related costs. For example, an investor may review their portfolio quarterly, but only rebalance if the actual allocation differs from their target allocation by more than 5 percent. This results in quarterly analysis which is important, while potentially limiting the rebalancing done during the year, reducing costs.

With the end of the quarter fast approaching it is a good time to begin reviewing portfolios and making sure that allocations have not strayed too far from target allocations. After all, it is the risk that is unknown that will hurt you more than the risk in which investors are aware.