Portfolio Rebalancing Strategies: Optimize Your Investments

Portfolio rebalancing is the process of realigning the weightings of a portfolio to maintain a desired allocation. Over time, as various investments perform differently, a portfolio can drift away from its initial target allocation. So, to correct this, portfolio rebalancing involves selling a portfolio’s best performing investments and using those proceeds to purchase more of a portfolio’s worst performing investments. The purpose of this strategy is to return the portfolio to its original or desired risk profile, ensuring that it continues to reflect an investor’s initial risk tolerance.

What is the best portfolio rebalancing strategy? And, should smart investors use portfolio rebalancing or avoid it?

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Why Rebalance?

Portfolio rebalancing serves as a popular tool for investors wishing to realign their portfolio with their risk tolerance. Over time, as some assets outperform others. A portfolio may inadvertently assume a risk profile that deviates from the investor’s emotional comfort zone. By periodically rebalancing, investors can ensure that their portfolio continues to reflect their desired comfort level.

Thee Ways to Rebalance

• Calendar Rebalancing
• Percentage-of-Portfolio Rebalancing
• Constant Proportion Portfolio Insurance

1. Calendar Rebalancing: This method involves rebalancing a portfolio at regular intervals, such as quarterly, semi-annually, or annually. Regardless of how much the portfolio allocations have drifted from their target weightings; the investor adjusts the portfolio back to its desired allocation on these set dates. This approach is straightforward and predictable, making it easy for investors (and their advisors) to implement.

• Percentage-of-Portfolio Rebalancing: With this approach, an investor sets predetermined tolerance bands around the target allocation for each asset. For instance, if an asset has a target allocation of 50% but drifts by a specified percentage, say 5%, and becomes either 55% or 45% of the portfolio, this triggers a rebalance. This method reacts to market conditions and ensures that allocations do not drift too far from targets, but it might lead to more frequent rebalancing depending on market volatility.

• Constant Proportion Portfolio Insurance (CPPI): CPPI is a dynamic portfolio strategy that adjusts the proportion of assets based on their performance relative to a safe asset, usually a bond or cash. The idea is to maintain a buffer or “cushion” that aims to prevent the portfolio from falling below a predetermined floor value. As the value of the risky asset rises, more is invested in it, and as it falls, more is moved to the safe asset. This strategy offers a form of downside protection, ensuring the portfolio value doesn’t drop below a certain level, but still allows for participation in potential upside from the risky asset.

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But… Should Investors Avoid Portfolio Rebalancing

There are strong arguments suggesting that investors should avoid traditional portfolio rebalancing for the following reasons:

1. Increased Costs: Rebalancing can lead to transaction fees every time assets are bought or sold. This can chip away at an investor’s overall returns, especially when rebalancing is done frequently. Moreover, many investment advisors promote portfolio rebalancing as a key strategy, leading investors to incur ongoing management fees which can compound over time, eroding the potential growth of their investments.
2. Tax Implications: Another significant concern with rebalancing is the triggering of capital gains taxes. When profitable assets are sold to rebalance a portfolio, these sales can result in taxable capital gains. Over time, these tax payments can significantly reduce the net returns of an investment.
3. Cutting Off Potential Winners: The act of rebalancing essentially involves selling outperforming assets in favor of underperforming ones to maintain a predefined allocation. This approach goes against the principle of a buy-and-hold strategy. Which, advocates for holding onto investments, especially those showing growth potential, to benefit from compounding returns over long periods. History has shown that a buy-and-hold strategy by investing in assets like stocks or real estate will outperform most other investment approaches in the long-run. By rebalancing, investors may miss out on this potential upside.

While portfolio rebalancing can help align investments with an investor’s desired risk tolerance.Tthe combined effects of incurring additional costs, triggering capital gains taxes, and potentially missing out on the extended growth of standout investments can negatively impact a portfolio’s performance over the long-term. It’s essential for investors to weigh these factors carefully and consider whether rebalancing aligns with their long-term financial goals and investment philosophy.

We invite you to contact us, or schedule a complimentary review of your situation, to explore how we can assist you in navigating the investment landscape with confidence and clarity.

Investment Advisors and Portfolio Rebalancing

Some investment advisors capitalize on our cognitive biases to sell us more of their services. By emphasizing the importance of maintaining a pre-determined asset allocation and highlighting the discomfort and perceived risk of deviating from this initial allocation, investment advisors encourage more frequent portfolio rebalancing. Which often leads to paying higher management fees and increasing the perceived value of advisory services.

By contrast, good Investment advisors spend less time on portfolio rebalancing and more time coaching their clients about how to overcome the emotional biases that prevent them from staying invested in the best performing investments for the long-run.

In other words, good investment advisors will “hold their client’s hands” emotionally. Because nobody ever became wealthy by holding a cash deposit. Only by accepting some risk do investors achieve returns that outpace inflation in the long-run.

How do Buy-And-Hold Investors Rebalance?

Buy-and-hold investors, by definition, minimize selling in their investments, but this doesn’t mean they never refresh their portfolios. In fact, successful buy-and-hold investors are constantly making new investments and re-positioning their portfolio.

Here’s how buy-and-hold investors can go about rebalancing without contradicting their overarching investment philosophy:

1. Using Dividends and Interest: Instead of reinvesting dividends and interest automatically, investors redirect payouts to purchase underweighted assets. This approach gradually shifts the portfolio and lets buy-and-hold investors update their holdings with high-potential investments.
2. New Contributions: If investors regularly add funds to their portfolios, like in a retirement account, they can use these fresh contributions to buy more of the investments that have become underrepresented due to market movements or add new investments that offer the greatest potential and exposure to new industries.

Tactical Portfolio Rebalancing for Buy-And-Hold Investors

For buy-and-hold investors who will rebalance solely using the income earned by their portfolio plus the new contributions they make, the decision of where to allocate this “new money” typically hinges on their investment goals and unique asset allocation strategy. Here’s how buy-and-hold investors might decide which investments to purchase next:

1. Compare Portfolio Weights: First, buy-and-hold investors should assess the current allocation of their portfolio. By comparing the present weight of each investment to a desired target allocation, buy-and-hold investors can identify which investments are underrepresented.
2. Prioritize Underweighted Sectors: “New money” should primarily be directed towards assets that have drifted below a target allocation or that provide the greatest potential, based on future expectations, not past performance. For instance, if the target allocation for a certain business sector is 20%, but due to stock market gyrations, this sector now represents only 10% of a portfolio, the investor may prioritize purchasing investments in this sector with the incoming funds.
3. Re-evaluate Individual Holdings: Many buy-and-hold investors hold their individual investments for decades, so they need to use “new money” to buy investments that currently under-represent certain characteristics in their portfolio. For example, a dividend investor who adds Microsoft to their portfolio once it begins paying dividends. Or the farmer who adds Real Estate Investment Trusts to their portfolio as they enter retirement.

Buy-And-Hold: Solution

Buy-and-hold investors can still rebalance their portfolio. But, they do so without the negative aspects associated with selling investments as mentioned earlier: increased fees, capital gains taxes, and stunting compound returns. To do this, buy-and-hold investors often use either the calendar or percentage-of-portfolio rebalancing methods.

For example, buy-and-hold investors using the calendar method might choose to make a new investment each week or quarter as dividends & interest are received. Legendary investor Warren Buffett even buys new stocks each day!

Or, using a percentage of portfolio method, buy-and-hold investors may spend their cash once it reaches a certain target amount. Legendary investor Stephen Jarislowsky uses this method by setting a maximum allocation to cash of 10%.

It’s the Next Best Decision that Counts

While we often find ourselves tethered to past decisions, it’s crucial to understand that we cannot change what has already transpired. The financial markets constantly evolve, with all known information swiftly assimilated into current prices. The value of an investment, whether it’s more-or-less than its purchase price, does not dictate its future trajectory. Instead of being swayed by the rear-view mirror, investments should be evaluated based on anticipated future performance. After all, past performance is no guarantee of future results, and our focus should always be on making the next informed decision.

Portfolio rebalancing is a backward-looking strategy that taps into our biases instead of providing for greater financial returns.

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