The Planner's Perspective: The Rebalancing Act

Paul Morrone |

By Paul Morrone CFP®, CPA, MSA

We’ve been blessed with generally positive market performance over the last several years. Yes, each asset class has had its good days and bad, but the general trend has been upward. Investors at the smallest and largest levels have enjoyed low volatility and steadily positive returns. Unfortunately, the uninformed investor may be in for a wild ride when volatility begins to rear its ugly head if they have not kept a careful eye on their investment allocation.

With an extended period of risk assets (i.e. stocks) outperforming more conservative investments (i.e. bonds/treasuries) the stock portion of many investors’ portfolios has grown significantly larger over the past several years. While this may help to bolster returns while things are good, complacency and euphoria often overpower logic and discipline during a bull market. One of the hardest parts of long-term investing is sticking to your strategic investment plan. This means managing your assets through both good and bad markets and rebalancing your holdings, when appropriate.

Periodic rebalancing may be necessary to mitigate the risk level in your portfolio to account for the differing growth rates of your holdings over time. While many asset management firms offer target date or target risk funds that help to automate the rebalancing process consistent with the fund’s investment objective, there are still many investors who choose to self-manage their assets. A portfolio that was originally created with a balanced risk level with 60% stocks and 40% bonds could easily have morphed into an entirely different portfolio that is 70% or even 80% stock after several years of an equity appreciation. The inherent risk characteristics of a portfolio weighted more heavily in equities may vary materially from what you think you own or, more importantly, what you want to own without proper analysis.

At first, it may seem counter-intuitive to sell a portion of your best-performing asset over the past several years and reallocate those funds into assets that have had less attractive returns. While this may hamper returns (albeit minimally) if the bull continues to run, over-exposure to equity may create unwanted heartburn if prices suddenly begin to decline. This theory also works when the pendulum swings the other way and prices have fallen. Your stock exposure at the end of a bear market may only be 40% (as opposed to the targeted 60%) because of depressed prices. Rebalancing the portfolio back to your desired target allocation of 60% may help increase the return potential of the overall portfolio as values rebound.

While it’s impossible to determine when the perfect time is to make a portfolio rebalance, it is prudent to review the overall portfolio on an annual basis to determine if one is necessary. This is especially important to review in employer retirement plans that have self-directed investment options. It is a best practice to review not just your salary deferral amount, but the contribution instructions (i.e. where the money is invested upon deposit to your account) on an annual basis. Over time, neglecting to address these issues can lead to an individual at or near retirement with an investment allocation that differs substantially from their actual risk tolerance.

Asset allocation does not ensure a profit or protect against a loss. Rebalancing a portfolio may cause investors to incur tax liabilities and/or transaction costs and does not assure a profit or protect against a loss.