After the portfolio has been created to match the client’s individual risk profile, changes in asset allocation are bound to occur as one asset class outperforms another. This makes it necessary to make occasional adjustments in the portfolio to return it to its original asset allocation.
A stock market with a bit of muscle, for example, could mean that a portfolio originally set to hold 60% of its value in equities now holds 70%. The gains are clearly welcome, but profits are only made by selling, and the overweighting in equities means the investors is carrying more risk than was originally intended. But rebalancing sometimes means selling off assets that are doing well, something many investors are reluctant to do.
“We naturally prefer to hold or invest in things that have done well because we think they will continue to do well,” says Jim Yih, founder of Edmonton-based CORE Financial Advisors. “On the other side, we cannot help but avoid or sell funds that have not done well because we think they will continue to lose. The only thing we know for sure is that everything goes in cycles.”
One obstacle that must be overcome in a rebalancing is the natural urge to hold on to all the winners and dump all the losers. Instead, what must often be done is to dump some winners and buy what may currently be weak investments.
“Rebalancing is such a simple concept, but it is not easy to do because it requires effort and discipline,” Yih says. “It requires that you fight instinct and use logic.”
Regular portfolio rebalancing is a smooth procedure when it is combined with a high level of service, high technology and knowledgeable investors, says Kevin Dehod, vice president and associate portfolio manager at McLean & Partners Wealth Management Ltd. in Calgary.
“Newer clients may have a few questions [about rebalancing], but most clients who have been through a full market cycle realize that it’s the prudent thing do so,” Dehod says.
At McLean & Partners, each client’s portfolio is composed of various targeted weightings and risk parameters in eight asset classes, which are decided by the firm each January. Proprietary software programs then monitor each portfolio in real time, and the portfolios are revisited regularly by the firm and each advisor.
Yih, on the other hand, rebalances his clients’ portfolios as part of their annual reviews. “We look at the allocation of the plan today, what it was a year ago and where it should be moving forward,” he says. “We then rebalance accordingly.”
Apart from a regular annual review, advisors should also consider an impromptu rebalancing if the portfolio’s weightings get too far off the original allocation at any time.
If an asset is a 15% weighting in the portfolio, you might rebalance if the weight moves to 10% or 20%, which is a plus or minus 5%, Yih says. You might also rebalance based on how much the asset moves off the original weighting. For example, if the original weighting is 15%, you might rebalance if it changes by 20% of the original, which would mean a movement of plus or minus 3% (20% of the original 15%).
McLean & Partners uses similar triggers. “An alert for us would be something like 20% over in an asset class,” says Dehod. “If a weighting went from 10% of the portfolio to 12%, then we would rebalance.”
The shifts in asset allocation, when required, are done with a delicate touch. Veteran investors know it’s always wise to take some chips off the table with a winning asset class and reinvest in areas that are currently weak but show good potential.
“That’s why they hire us,” Dehod says. “It is not an easy decision to make for a client. We’re making the calls, and the shifts are subtle. Education and knowledge are key.”
Dehod notes, for instance, that the firm had a solid overall weighting in Canadian equities for its clients last year but it has thinned the weighting down slightly in 2006 because of the strong performance of the domestic markets. The general weightings in the struggling U.S. market, by comparison, have been a modest 5% for the past two years.
Yih says that age and any dramatic change in lifestyle can also mean it’s time for a re-evaluation of investment goals and a portfolio rebalancing.
@page_break@”The asset allocation needs to change as the client’s lifestyle, age or wealth changes,” Yih says. “Every time you go to rebalance, you should ask yourself if the weightings need to be changed to reflect life changes.”
Experts agree that the regular rebalancing of a portfolio can increase its value; the estimates of how much generally range as high as 5% gains to gains of 1% over the long haul.
Yih once put the theory to the test by creating a scenario that begins in 1990 and involves two Canadian investors with $100,000 apiece. They each bought identical investments in a portfolio that was 20% invested in each of five asset groups: Canadian equities, global equities, bonds, income trusts and cash.
Using historical data from Morningstar Canada, he then calculated what would happen if the first investor did absolutely nothing over time and the second investor rebalanced the portfolio once a year to maintain the original 20% asset allocations.
After 13 years, at the end of 2003, the first “buy and hold” portfolio had grown to $300,753 and had a compounded return of 8.8%. The rebalanced portfolio did even better, reaching $310,632 and a return of 9.1%.
Not a jaw-dropping advantage, but significant nonetheless. IE