The cornerstone of effective personal financial planning is discipline. Discipline in establishing plans to accomplish quantifiable goals in a reasonable amount of time, and the discipline to stick to those plans thereafter. It is very likely that according to your specific situation, you could have a number of different goals; with some being more concrete than others. For example, everyone must at some point have enough savings to provide for their own retirement in old age, and so planning for this financial liability would be imperative for anyone not planning to win the lottery; whereas some goals might be more variable in probability or timing, like saving up to purchase a vacation home. These goals of varying distance and risk would then necessitate differing savings and investment strategies, and portfolios. After establishing with a professional the ideal course of action to take for each goal, the work is far from finished. Each year, perhaps more than once per year, the portfolios should be reviewed and perhaps rebalanced.
What is a portfolio rebalance, and why is it necessary?
Take for example the above mentioned case of someone saving for retirement. Perhaps due to their risk appetite, the current market climate, and the number of years until their expected retirement age, this person and his financial advisor determined a portfolio allocation of 50% in equities and 50% in bonds is most appropriate. If in the following year equities grow by 15% and bonds grow by 4%, then while his portfolio would have grown by a respectable amount, it would however now also be out of balance. If performance divergence of asset classes within his portfolio were to continue, this example investor could find himself significantly overweight or underweight in a particular asset class. This could cause him to be overly exposed to certain types of risk if overweight certain investments, or not poised to take advantage of particular opportunities if underweight other investments. Accordingly, it would be prudent to revisit portfolio weightings on a regular basis in order to determine that the current asset position is in line with overall strategy and goals.
There are a number of other benefits to portfolio rebalancing in addition to the basic fundamentals of keeping on track with your specific financial goals and risk adjusted return preferences. Portfolio rebalancing offers the opportunity to lock in gains from any particular funds that may have been out-performing, as well as use these proceeds from sale to then purchase more of other assets which may have been recently over-sold by the market and as such are now under-priced.
However, the above example is a double-edged sword. Selling off a fund that has just provided 15% growth in the last year could simply mean you miss out on another 15% or even 20% of growth in the following year. Additionally, using the proceeds from sale to purchase more of an asset that has just lost 5% could also continue to experience downward market pressures. The old adage of “don’t throw good money after bad” is alive and well in the portfolio rebalancing world. Accordingly, it is crucial that such opportunistic portfolio rebalances be done for the right reasons and not simply because of emotions felt when looking at the asset’s previous year performance graph. A financial professional would have the experience and industry knowledge to assist you in properly determining the best course of action in rebalancing your portfolio.
Another key factor in determining the appropriateness of a portfolio rebalance is the various costs of doing so. For example, there could be quantifiable transaction costs for making specific trades within your portfolio. For larger accounts with not many positions, this should not cause too great an impact. However, if you have a smaller account with dozens of assets in custody, it could be quite costly to sufficiently rebalance them all out. In addition, you may have to consider the tax consequences of selling off certain assets. As described above, portfolio rebalancing typically would involve selling off better-performing funds, which usually triggers a short term or long term capital gain tax liability; which would need to be taken into consideration when determining the appropriateness of the rebalance.
However, some types of private pension accounts could actually negate both these costs. For example, some types of accounts are able to offer a certain number of free fund switches per year. This likely would not enable you to treat it as a day-trading account, but it would certainly account for a regular portfolio rebalancing. In addition, with long term planning, tax efficiency is very often part of the overall strategy. In other articles we have spoken at length regarding certain types of government sponsored tax efficient vehicles for long term financial planning; and as very often is the case, these accounts provide what is referred to as “gross rollup”. Gross rollup is in a sense the ability for you to be free of all forms of taxation as long as the funds remain in the retirement account. For example, if you have a blue-chip fund paying out steady dividends or bonds paying out interest, you would not be liable to taxes on these distributions. In addition, if you are making a regular portfolio rebalance of this particular tax-efficient account, you would not be immediately liable for taxes made on the gains from selling some of your out-performing positions.
Portfolio rebalancing is a necessary aspect of prudent long term financial planning. How and when to rebalance, and for what reasons, largely depends on the particular investor’s circumstances, as well as present day market conditions. As described, particular types of accounts are also more amenable to rebalances as well, providing lower costs and deferring taxes.