Sticking to a disciplined strategy of regularly rebalancing a portfolio back to its target asset allocation can often seem counter-intuitive.
This includes in the prevailing low-interest investment environment with expectations for lower returns over the medium-to-long term for broadly-diversified portfolios.
In short, portfolio rebalancing can be an emotional decision for investors, requiring the selling of currently outperforming assets to buy currently underperforming assets.
The basic reasoning behind periodically rebalancing is to recapture a portfolio’s intended risk-and-return characteristics.
Smart Investing has discussed in recent weeks how a broadly-diversified portfolio’s asset allocation is the primary driver of its return variability over time and how a portfolio can become progressively more volatile and risky without periodic rebalancing.
In late 2015, Vanguard published an updated research paper Best practices for portfolio rebalancing, making the point that the primary benefit of rebalancing is to maintain a portfolio risk profile, not to maximise returns.
"Many investors spend substantial time defining their investment goals and selecting an asset allocation to help them achieve those goals while also being mindful of their tolerance to risk," Vanguard analysts comment. "To be successful, however, they must be able to stick with their plan in all kinds of markets."
When the share market, for instance, is performing strongly, investors without a disciplined rebalancing strategy may be tempted abandon their strategic asset allocation to let their exposure to equities keep growing. This makes investors vulnerable to a share market correct, perhaps jeopardising their chances of meeting their financial goals.
By contrast, when the share market has fallen sharply – such as in the depths of the GFC – investors without a set rebalancing strategy may be tempted to hold an insufficient exposure to shares. This may be in conflict with their tolerance to risk and financial goals.
Disciplined rebalancing is an insightful strategy for all investment seasons. It provides a means for investors to keep spreading their risks and opportunities.
This research paper on good rebalancing practices looks at alternative ways that investors can use to trigger the rebalancing of their portfolio’s asset allocation, focussing primarily on three:
Strategy one. "Time-only": With this approach, the only consideration is time – not how much a portfolio has drifted from its strategic asset allocation. For instance, investors following this approach might rebalance, say, annually or at set times during a year.
Strategy two. "Threshold only": Under this strategy, a portfolio is only rebalanced when a portfolio has drifted from its strategic asset allocation by more than a predetermined percentage, such as 5 per cent. One of the drawbacks of the "threshold only" approach is that the portfolio would require consistent monitoring.
Strategy three. "Time and threshold": With this approach, the portfolio is rebalanced at a scheduled time, such as annually, only if its asset allocation has drifted by more than a predetermined minimum of, say, 5 per cent.
The research paper concludes that for most broadly-diversified stock and bond portfolios, annual or semi-annual monitoring with rebalancing at 5 per cent thresholds "produced a reasonable balance between control and cost minimisation".
It should not be overlooked that rebalancing often involves transaction and tax costs. Much depends on the circumstances of the investor and the rebalancing strategies adopted.
A good adviser can add value by helping an investor set an appropriate strategy for periodically rebalancing their portfolios in a non-emotional, cost-effective and impartial way.
