Money Matters: A forgotten key element in investing: Rebalancing

 Travis Gallton, The Daily Record Newswire

While at social events with friends and family, I typically get asked: “Where should I put my money?” or “What’s currently the hot investment trend?” I typically stress that if you’re investing for a long-term goal, stay the course and focus on appropriate asset allocation decisions to meet your return objectives. I respond with this answer because, academic studies show, up to half of the variability in a portfolio’s return can be attributed to asset mix choices (i.e., stocks, bonds, and alternative investments).

With the virtual disappearance of defined benefit plans (pensions) and the emergence of most companies offering defined contribution plans (e.g., 401(k) or 403(b) plans) the employee has become more and more responsible for their investment success. In fact, according to the Employee Benefit Research Institute, by the year 1990, defined contribution plans topped the percentage size of defined benefit plans in the private sector.

Compared to the past, when employers played a large role, employees now bear all investment risks for choosing their appropriate asset allocation, as well as the responsibility for ensuring their portfolio is rebalanced on a periodic basis.

Often, when individuals begin to invest in their 401(k) or 403(b) plan, they select their asset allocation depending on their risk tolerance and return expectations. However, as time passes, the market can cause an individual’s original asset allocation to drift away from their original allocation mix. This can negatively impact their ability to meet their stated objectives. Rebalancing is what many individual investors typically forget to take action upon.

To illustrate the risks of not rebalancing, I have included a table (see below) as if your portfolio was allocated 50 percent in the average domestic equity mutual fund and 50 percent in the average fixed income mutual fund. Thus as the table shows, you have essentially taken on more equity risk than previously planned.

To combat this risk, there are various options investors can take when it comes to rebalancing. Most individuals prefer to use a calendar rebalancing technique. Calendar rebalancing is where an investor rebalances back to a strategic allocation on a pre-determined basis, i.e. monthly, quarterly or yearly. The obvious benefit is that it provides discipline without investors having to constantly monitor the market. However, the main drawback could be large oscillations among asset classes between your rebalancing dates.

Another technique to use is to rebalance on a target percentage of the portfolio (PPR). The PPR technique is where individuals rebalance based on a threshold or a tolerance band for an asset class, e.g., a range of a certain percentage. The optimal tolerance band is typically determined by a client’s risk tolerance, transaction costs involved, and the tax liability the investor could incur. The primary benefit of PPR rebalancing is that it tends to minimize the degree of shifts in various asset classes by locking in gains. Alternately, the main drawback is that investors must constantly monitor the market.

Institutional investors and active managers are more likely to use the PPR strategy as they will make tactical active tilts from the strategic asset mix depending on current market conditions. In addition, institutions can employ more dynamic rebalancing strategies such as a constant mix strategy or a constant proportion strategy. The constant mix rebalancing strategy is contrarian in nature and typically outperforms in either a flat or highly volatile market. In contrast, the constant proportion strategy adds assets to those that are rising, which leads to it outperforming in a trending market.

As the discussion here shows, it is important for investors to periodically revisit their asset mix and rebalance not only due to changed circumstances of the investor’s life, but also due to the effect of passage of time and market movements. Rebalancing allows investors to maintain their desired exposure to a desired asset mix (desired risk factors), provides a discipline and teaches investors to stay focused, and enhances returns and reduces risk over a long-term horizon.

If you are unsure of how you should approach the issue of rebalancing your portfolio, speak with an investment advisor to further understand your options on this forgotten, but key element in achieving your investment objectives.


Travis M. Gallton, CFA, is a senior equity portfolio manager for Karpus Investment Management, a local, independent, registered investment advisor managing assets for individuals, corporations, nonprofits and trustees. He can be reached at (585) 586-4680.


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