What is rebalancing?
When an investor sits down with their advisor, one of the most important decisions that they are going to make is their asset allocation (how much, as a percentage of your total wealth, to allocate to each asset class such as equity or bonds). Once this agreement has been implemented, the process of rebalancing is to constantly bring the “real life” portfolio, which can easily drift from this target, in line with the original long run target weights. This “drift” may occur if equity has performed well and increased in weighting from 50% of your portfolio to 60% (the same good performance and drift could also be experienced by other asset classes); the intention would be to sell the additional 10% of equities and distribute the profit to the other assets in your portfolio. The same goes for a decrease in asset class weighting due to poor performance.
We understand that rebalancing may go against human emotions. Why should one sell an asset class that is performing well to buy an asset class that is performing poorly? This question is justified in that allowing portfolio drift to occur (“the weights of the best performing asset classes tend to increase at the expense of poor performing asset classes” [Zietsman, 2015]) will result if your portfolio to performing better in an upward trending market. The problem comes in when the market reverts to its long run average; which portfolio performs better during these markets? It has been shown that a portfolio which is rebalanced holds its ground in these market conditions.
Rebalancing in my opinion is the only time an investor and their advisor should perform the “buying low and selling high” technique, this approach is the essence of investing and without a structured approach to long run asset class weightings greed or fear could reign supreme and we could detriment long run portfolio performance.
Rebalancing also reduces concentration risk. It is easily understood that if you do not rebalance your portfolio, the fastest growing asset will become the greatest proportion of your investment over time. Everyday investors are also aware that for greater risk you should expect to receive greater return. This then means that your un-balanced portfolio has become more risky than originally intended due to the fastest growing asset class becoming a greater proportion of your investment. An investor should also keep in mind a principle called Siegel’s paradox: this principle highlights that an investor who starts on R100 and then has a negative period of -50% will end on a balance of R50. Most people automatically assume that in order to “break even” you would need to make back 50% in returns; this would rather need to be 100%. Making a 50% return on R50 would lead you to end on a balance of R75. A wise investor knows that limiting downside losses results in a portfolio that may perform better over time, this is extremely important when an investor lets the fastest growing asset “drift” towards becoming the largest component of their investment despite a specified weighting being given upon implementation of the investment.
When rebalancing, it is very important to not focus on what your current holdings are but rather what will be the best portfolio going forward. A test that I like to use is the “forced cash test”; if all your investments were liquidated into cash and you were forced to start from scratch again, what you decide to include in your portfolio? This is a good way to identify if any changes need to be made to your current investment.
A professional wealth planner would be able to help you implement a strategy, while being able to employ the various rebalances techniques that exist [these will not be touched on here]. The cost of sitting down with a professional may seem quite high but when compared to the losses experienced by a neglected or unprofessionally managed portfolio, they pale in comparison.
Robert Starkey – Wealth Planner