We are starting a new series of blog posts looking behind the scenes how we manage portfolios for our ongoing clients. Many of these things have been discussed various levels of detail in the past, but we wanted to give you a full picture of what happens on an ongoing basis.
Let’s begin discussing “Rebalancing”
There are many industry terms when it comes to Portfolio Management that are thrown around, with one of the most frequently discussed being “Rebalancing”. Even I am guilty of using that term and moving quickly past it, without taking time to explain the nuances that go into incorporating rebalancing a portfolio. In this post, I wanted to “peel back” the curtain and reveal one of the ongoing processes that we incorporate in managing our clients’ investment portfolios.
First, what is Rebalancing?
As you know, we have a target asset allocation, which is just a target percentage of the portfolio to be invested in all the different areas you are invested in. But, within a day of our initial purchases, the various stock and bond markets move, causing your portfolio to “float” away from your perfect target asset allocation. the question is, when, if ever, do we “rebalance” your portfolio back to the target asset allocation percentages. As in, when do we sell the investments that have gained in value relative to the rest of the portfolio, to buy those that have dropped (or increased less) than the rest of the portfolio? That’s rebalancing.
Why Do I need to Rebalance?
For many investors, this question is initially crazy. Why would you want to sell the investments that have increased in value to buy those that have dropped? Naturally, we all want to own the winners and sell the losers. But this is precisely why we need to have a disciplined, researched, well-thought-out approach to managing the portfolio so that natural emotions don’t get in the way of good financial decisions.
The primary reason for rebalancing is less about increasing returns and more about managing risk. As we set a target asset allocation, we two key factors:
1. How much risk (or return) do we need to take (or earn) to achieve your goals and
2. How much risk can you emotionally handle without making financially damaging decisions, such as converting every investment into cash in a major downturn.
If we have made the appropriate decision in setting your target asset allocation, the further away from the target your portfolio floats introduces too much or too little risk.
For example, let’s imagine a $1,000,000 portfolio with only two investments, stocks, and bonds. And let’s set the beginning, appropriate target asset allocation of 50% stocks ($500,000) and 50% bonds ($500,000). In the subsequent 6 months, imagine that stocks have increased by 10% to $550,000 and bonds have dropped 5% to $475,000. Now, if we do nothing, your total portfolio, worth $1,025,000, is 54% stocks and 46% bonds. Back to our question: Should we do anything? Should we sell stocks to buy bonds at this point? The answer: Maybe.
This is where the combination of rebalancing “bands” and frequency of “looking” come into play. Financial industry expert Michael Kitces provides a great review of the 2007 study by Gobind on this topic. The key is to let the portfolio naturally move around the look frequently enough at Rebalancing Opportunities to place trades when the portfolio moves too much. At Illuminate Wealth Management, we look one to two times per month across each client account and total household portfolios, to compare the current allocation to the targets. Then, if any asset class is more than 20% away from its target, we’re likely to place a trade to rebalance.
Going back to our example, with a 50% stock / 50% bond target, the new allocation is 54% stocks and 46% bonds. In this case, stocks are not even halfway high enough for us to trigger a rebalance (only 8% out of range). Unless there are additional factors, such as a need for money from the portfolio, we are unlikely to place a trade in this scenario.
Cash Management of Dividends and Interest
There is one more main factor that reduces the frequency of needing to place trades: we intentionally target dividends and interest to go to cash, rather than automatically reinvesting back into the same securities. For instance, if these stock funds paid out $5,000 in dividends, we can use this money to purchase bonds instead of automatically buying more stocks that are already above our target of 50%. Having income paid in cash allows us to significantly decrease the frequency of sales and instead just focus on using purchases to bring the portfolio back to the target.
Taken all together, there are many factors to consider when choosing when to buy/sell securities in a portfolio. Hopefully, this quick summary gives you more insight into the intentional decisions we make behind the scenes as we manage investment accounts.
We’re happy to discuss all this and more at any time. Please reach out if you have any questions!