Portfolio Rebalancing is Critical for Investment Success
The systematic rebalancing of an investment portfolio back to target allocations offers many benefits. Rebalancing keeps a portfolio at a specified risk level, potentially increases returns, and enforces the discipline of selling asset classes that have increased the most in value relative to others.
Menlo Park, CA (PRWEB) November 6, 2004 -- A proper investment plan places target allocation weightings for each asset class in a diversified portfolio. As markets fluctuate, the allocation of the portfolio will move away from these targets.
"Left free to drift, a portfolio can evolve into one with an asset mix that has decidedly different risk and return characteristics than intended," says Dan Goldie, a financial advisor to wealthy individuals and families in Menlo Park, California. "Rebalancing is the adjustment of a portfolios asset allocation back toward its target proportions."
Few individual investors apply the discipline of rebalancing on a regular basis. In fact, studies show that they actually engage in the opposite behavior. Instead of selling assets that have appreciated the most relative to others in their portfolio, they purchase more of these assets at higher and higher prices. According to Mr. Goldie, "This behavior of chasing returns potentially hurts overall performance in the long run, and also exasperates the portfolio imbalance already caused by market fluctuations."
Most financial advisors employ some sort of rebalancing strategy in their portfolio management routine. Some use fixed rebalancing that is done on a regular timetable. Others rebalance more haphazardly, without a definitive plan in place.
Traditional rebalancing strategies can be sub-optimal and may result in unnecessary transactions, increased realized capital gains, or both. "A more sophisticated approach to rebalancing involves more than automated procedures and mechanical trading rules," says Mr. Goldie. "Professional judgment and the specifics of each clients situation and preferences must be an integral part of the process."
Mr. Goldie has consulted with academic and professional researchers to help him devise a unique approach to rebalancing that involves the following:
(1) Rebalancing trades only occur when expected benefits exceed expected costs. The frequency of rebalancing opportunities cannot be predicted reliably. Their occurrence depends on random relative movements of asset-class values. When asset-class returns diverge quickly and repeatedly, profitable rebalancing opportunities may occur frequently. Alternatively, when asset-class returns tend to move together over prolonged periods, profitable rebalancing opportunities may occur infrequently.
(2) Costs are lowered primarily by reducing realized capital gains and brokerage fees. Examples of ways to reduce realized gains are to place rebalancing trades inside tax-deferred accounts when possible, using new money to rebalance accounts, and harvesting losses when possible.
(3) Portfolios are reviewed frequently for possible rebalancing opportunities. Mr. Goldie and his team review portfolios weekly.
(4) An asset class must be sufficiently away from its target allocation to be considered for rebalancing. This non-trading" region is larger for more volatile asset classes and smaller for less volatile classes. Rebalancing should only be considered when an asset is beyond its specific threshold.
Dan Goldie is an independent financial advisor to individuals and families. He is located in Menlo Park, California. Investment Advisory services provided through Partnervest Advisory Services LLC.
