“Portfolio rebalancing” is a term that investment professionals sometimes toss around as if its meaning is universally understood. Years have taught us otherwise, however. Rebalancing is a basic component of investment management that entails returning a portfolio to its target investment objective.
Well-designed investment portfolios follow guidelines that specify the proportions and kinds of asset types permitted in the portfolio—the target investment objective. The investment guidelines usually provide a range of permissible percentages for equity assets (as equities are generally riskier, they comprise the aggressive portion of the portfolio) and fixed income assets (the defensive portion of the portfolio). When your portfolio drifts too far from the specified ranges, you may expose yourself to undue risk; then rebalancing might be in order.
The first thing to decide is when to rebalance the portfolio back to its target percentages. For this brief discussion, we will assume that the target objective is appropriate for the given investor; that return streams are mean-reverting; and that the aggressive and defensive segments are not highly correlated. Each of those assumptions could (and may well be) the topic of its own expository excursion, but for now, we’ll focus on rebalancing.
Pertinent factors to contemplate when choosing the timing of a rebalance include:
- The frequency of data collection and portfolio valuation—how good are your data?
- Volatility of the aggressive and defensive segments of the portfolio
- Transaction costs in the available investment mediums—how much does it cost to make the changes?
- The quality of the decision; i.e., the probability of a correct decision along with the costs of an incorrect decision
In this age of powerful personal computers, one could value a portfolio daily (or even in real time). It is not, however, likely to lead to a productive result. While one might reasonably choose to rebalance annually, more frequent data sampling permits a high-quality decision with statistical comfort. Monthly or quarterly valuations are certainly reasonable frequencies to gather data for rebalancing decisions. Also, there may be psychological advantages to frequent valuation even if rebalancing is less frequent.
In an ideal world, we might sample the data and rebalance more frequently in volatile markets and less so in quiet and dull markets. Of course, the more we rebalance, the higher the cost: rebalancing incurs transaction costs, taxes and the potential loss associated with making an incorrect decision. Also, the cost of the time of the people performing the calculations and implementing the rebalance is a factor. Holders of large portfolios may pay administrators to do this work while smaller portfolios are better left to professional advisors that use mutual funds to allocate assets. If the sums are large, and investment committees are involved, rebalancing decisions frequently become encumbered by politics, bureaucratic delay and indecision. Alternatively, if a single individual is rebalancing his portfolio, another set of psychological factors often becomes evident.
The psychology of rebalancing is quite difficult. Few individuals and fewer investment committees can sell in rising markets while their defensive segment earns only interest. Conversely, adding to the aggressive segment in a bear market is also difficult. Essentially, the rebalance requires selling outperforming positions (within the portfolio) to buy underperforming positions. Think of it: If the investment guidelines specify 40% held in equities and 60% held in fixed income, and the portfolio is currently at 52% equities and 48% fixed income, the aggressive equity portion has done very well while the fixed income, necessarily by comparison, has not. So a rebalance would entail reducing that equity position by 12% and increasing the fixed income by the same percentage. This move is wise because of the mean-reverting nature of returns; it also calls for discipline and a strong stomach.
HOW TO REBALANCE
One simple, cost-effective, and easily implemented method is called “cash flow rebalancing.” You value your portfolio at market whenever you need to add or withdraw money. Then you add or take those sums from the portfolio segments that adjust the portfolio back to the target portfolio guidelines. In the example given a moment ago, you would sell some of that 52% equity position to raise cash for a withdrawal; if you were adding funds, you would buy fixed income to move that 48% closer to the desired mark. (In the real world, you might sell 12% of the equities, take your withdrawal, and then invest the leftover cash in fixed income to rebalance your portfolio.)
Cash flow rebalancing works well when done once a year. Two typical cases are IRA withdrawals and withdrawals for living expenses from taxable portfolios. If you are over age 70 ½, you must take a required minimum distribution (RMD) from your IRA each year; meeting this withdrawal requirement is a perfect time to rebalance. For individuals living off their portfolios, it is generally best to withdraw an amount covering six to twelve months of living expenses and deposit this sum in a money market fund. It is usually possible to select tax lots, stocks or mutual funds that will permit long-term capital gains and/or the offsetting of losses against gains. If investment decisions require substantial changes, the taking of short-term losses should be attended to.
Cash flow rebalancing is also useful when building a portfolio either with a series of lump sum investments or with a periodic investment plan like dollar cost or value averaging. These methods work in IRAs, 401k-type plans or after-tax investment programs.
PSYCHOLOGICAL ISSUES IN REBALANCING
While periodic or cash-flow driven mechanical rebalancing seems easy enough on the surface, it is often quite difficult to accomplish. The fundamental challenges are greed and fear.
An understandable reason for this difficulty is that by rebalancing the investor may be taking gains and facing a tax bill. No one likes paying taxes and to avoid them by not rebalancing seems sensible. This is especially true when you calculate how much money you have left after the tax bill and compare it to how much the market would have to decline to cost the same amount as the tax.
Bull market environments that require the decision to pare back the stock portfolio and invest in the sluggish bond portfolio are always difficult. Sometimes investors view this step as selling the winners and buying the losers; selling in a bull market is not an easy portfolio decision for any investor. The prospect of capital gains taxes offers an easy rationale to avoid rebalancing. It is not uncommon after a prolonged bull market to see a portfolio of stocks that is overwhelmingly weighted in the winners and totally undiversified on issue size, sector, and industry. In 1999, portfolios were over-weighted with technology and in 2005, with energy. This result is the product of holding the winners; as the winners gain in relative market value in the portfolio, the losers shrink into insignificance.
Bear market rebalancing is not any easier. This strategy requires selling the safe bonds and buying the risky collapsing stocks just when you might be losing your job or, in the case of an institution, suffering a slowdown in cash flow.
Another typical reason for procrastination in rebalancing is that it may require taking capital losses; many people abhor taking losses and have the view that, by waiting, the market will come back. This reason is especially visible when the rebalancing requires selling a favorite stock.
CONCLUSION
Rebalancing an investment portfolio implies that the investor has selected an appropriate balance between risky assets and less risky assets. This balance is usually specified in an “investment policy” statement or guideline. For rebalancing to have a positive effect the return streams of these two asset classes should not be highly correlated and have a tendency to be mean reverting; in layman’s terms, we might say “…what goes up will go down and vice versa.” This positive effect can come from two sources, risk reduction, and higher return. Risk reduction results from selling the overweight position in risky assets and purchasing the underweight defensive assets; the higher return comes from mean reversion in the return streams.
For most investors, cash flow rebalancing is the most efficient and psychologically the easiest to employ. This rebalancing takes place when funds are added or removed from the portfolio.Labels: Research