Do You Know When, And How, To Rebalance Your Portfolio?

A properly-designed investment portfolio should be designed to support your goals and time horizon, built around your own tolerance of risk, and diversified to provide managed risk distribution. Diversification is the process of building a portfolio from a number of different assets, a strategy that limits the impact any one asset can have on your overall portfolio for better or worse. Basing the allocation of your overall investment on your tolerance for risk gives you the ability to define the risk / reward profile of your investment portfolio to follow suit. We hear a lot of questions from investors who see the value of this approach but don’t know how to put it in action – so here’s a quick primer on the basics of maintaining a balanced portfolio.

What does it mean for a portfolio to be balanced?

To avoid a concentrated position, defined as an overly high percentage of one’s portfolio devoted to one investment, the total value of a portfolio can be divided among several different types of investments. These groups are known as asset classes, groups of assets that have similar characteristics, behaviour, and regulation. The most broadly used terms here are stocks, also referred to as equities, fixed income instruments (bonds), cash, and alternative investments (real estate, physical goods, and others). Typically, investors’ portfolios are made up of a mix of stocks, bonds, and cash, and what portion of your portfolio each of these asset classes represents gets determined by the desired risk / reward profile of the collective assets. This is what is known as a balanced portfolio. For today’s purpose, let’s focus only on stocks, bonds, and cash.

How does my risk tolerance factor in, and how do I determine my tolerance?

Your own comfort level with, and ability to consider, investments that may offer greater returns – but that also tend to carry higher risk due to their typically higher likelihood of fluctuation in value – is a primary factor in creating a portfolio that is truly a good fit for the investor. Many people think of themselves as being very aggressive with risk, or very conservative, or somewhere in the middle. Often, this is as detailed as that definition gets for the average retail investor.

There’s a lot of value in knowing your real, measured tolerance, however, which is why we use a process that allows individuals to discover where they stand with much greater precision here at BFA Wealth Management. We walk our clients through an informational evaluation, then put our findings and figures through powerful software that uses multi-faceted algorithms to express each individual’s risk tolerance as a score between zero and 100. The higher the score, the less averse to financial risk the individual is. With an exact figure to work with, we can then balance a portfolio for each of our clients such that the mix of assets within creates a risk / reward profile truly in line with each investor.

How does that strategy work in practice?

For example, if your risk tolerance is on the lower end of the spectrum, a larger percentage of your assets should be conservative ones such as investment-grade bonds, more likely to remain stable yet less likely to produce dramatic returns. The remainder of your investment may then be allocated to other assets such as stocks with a slightly greater potential for more significant returns, and thus also a slightly higher risk potential.  We also advocate for an allocation to cash, which can be used as a risk management tool as well as a liquidity reserve that can allow you to capitalize on market inefficiencies quickly and without costs typically associated with asset sales.

By allocating more of your investment to conservative choices, your exposure to risk from more aggressive investments is limited by your smaller allocation to them. Although your potential to realize upside gains is lower in this scenario, your overall portfolio remains in line with your true risk tolerance, while affording more upside potential than a portfolio of assets that are each strictly in line with your comfort level with risk.

In an inverse scenario, an investor with a higher risk tolerance may wish to allocate more of their investment to assets with greater potential for both upside and risk, while still maintaining a healthy allocation to conservative choices. Both of these scenarios distribute risk potential among multiple asset classes, reducing the impact that any gain or loss from any one asset will have. Armed with your true risk tolerance score, you can then assemble a portfolio that balances your desire for growth with your need for capital preservation.

What advantages does this strategy offer?

This risk management process, and the balanced portfolios it can produce, is intended to allow investors on either end of the risk tolerance spectrum to enjoy more of the advantages of investments they may not have considered. More risk-averse individuals can position themselves for more upside opportunity, while more aggressive investors can pursue assets with higher risk potential without moving entirely away from choices geared toward capital preservation.

Although creating a balanced, diversified portfolio is an excellent strategy for any investor, this is not the last step in a process that should evolve with the investor and the broader market. Of course, your goals or risk tolerance may change over time, but for today’s exercise, let’s imagine that they do not. Even still, that balanced portfolio you created is very unlikely to remain perfectly in harmony with your original allocation over time, for several reasons.

Why would my portfolio become imbalanced if it was balanced properly at first?

As returns differ based on market conditions, and since a balanced portfolio should contain a mix of assets likely to produce differing returns in the first place, time will bring your portfolio out of balance naturally. That’s not a bad thing by itself – for instance, imbalance can come about swiftly courtesy of excellent returns. In addition, it is not uncommon for asset classes to exhibit non-correlated behavior, meaning that one asset class performing well often is a result of conditions that cause other asset classes not to achieve the same performance.  Also, stocks tend to be more volatile, fluctuating in value more dramatically than bonds, so portfolios with higher allocations to equities are more likely to experience significant changes in value. When these fluctuations occur, the balance between more conservative and more aggressive investments in your portfolio changes, causing a shift from the original allocation and thus an imbalance.

What situations can make this happen?

Here’s a quick example, purely for illustration.

Let’s say that your balanced portfolio starts out with an investment of “X” dollars, and for the sake of easy math and to demonstrate these concepts, let’s also say that your portfolio is divided into just two assets. One is very conservative, and the other is more aggressive. Your decidedly moderate 50% risk tolerance score is used to create a portfolio with a complimentary risk / reward profile, in this case by incorporating one asset from either side of the scale.

Now let’s take a look one year later. Your conservative allocation has stayed roughly flat, but your aggressive choice has doubled in value. Congratulations – your portfolio is now worth 150% of your original investment. However, you now also own a portfolio in which 66% of your assets are very aggressive, and your portfolio is now severely misaligned with your true risk tolerance. While you started out with a strategy intended to divide your investment funds equally between capital preservation and pursuing opportunity, and your first year produced amazing results, you are now devoting twice as much of your portfolio to aggressive choices as conservative ones - and you’ve got more at stake now, too.

While this is an exaggerated example purely for proof of concept, hopefully you can see the value in reviewing your portfolio and rebalancing your allocation to maintain the risk management and other advantages that compelled you to diversify your holdings in the first place. Now that you know why you should, you are probably wondering...

When should I rebalance my portfolio, and what should I look out for?

There is no magic formula to work from here, but evaluating your portfolio for proper balance according to your risk tolerance and goals should never be ignored for too long. In addition, portfolios aligned with higher risk tolerances may have a higher potential to become unbalanced in less time than more conservative portfolios, and should be evaluated more frequently. Portfolios that include higher allocations to stocks are more likely to behave in this manner.

Some investors feel comfortable examining the balance of their portfolios annually; some wouldn’t dream of letting more than six months pass. Rebalancing too frequently can carry additional costs and tax considerations that can outweigh the impact of rebalancing, and waiting too long may expose you to more risk than you are comfortable with – or prevent you from taking advantage of an opportunity you would otherwise have elected to pursue. Additionally, your strategy for rebalancing should be decided at each examination, not set and adhered to regardless of the circumstances of the imbalance. That’s another reason why allocating some portion of your portfolio to cash can make sense; cash provides a reserve of liquid capital that can be used to adjust portfolio balance through asset purchases.

So how do I rebalance my portfolio if I decide that the time is right?

That depends on several factors, the biggest two being the reason for the imbalance and any costs or other considerations associated with your potential methods of rebalancing. For example, if your portfolio is out of balance due to an asset class that has performed above expectations, you may not feel comfortable allocating your now-higher percentage of your portfolio to that asset class, as it may be more likely to lose some of its present value by the time you rebalance again. In this situation, you may decide that it is worth it to sell some of these assets in order to purchase others in a different asset class, achieving your desired balance again while enjoying a higher return than anticipated - even after accounting for any potential cost or tax considerations associated with the sale. Alternately, if your portfolio contains assets in three classes, and two of those asset classes perform only modestly better than anticipated while the performance of the third is greater, you may elect to rebalance by simply allocating a greater percentage of your contributions to the third asset class until the next time you evaluate your portfolio’s state of balance.

Building a diversified portfolio to suit your needs and goals is a very complex process. Maintaining its intended balance brings that complexity to new dimensions as asset values change, markets fluctuate, and your risk tolerance has time to evolve. That’s why it’s so important to create a plan that is uniquely tailored to you from the start. From there, you can assess the appropriate intervals and methods for rebalancing your portfolio on a rolling basis, accounting for all of the factors that have impacted your assets to date, as well as any new potential opportunities.

What can I do if I don’t feel comfortable making those decisions, or don’t have enough free time to devote to my investments?

If you want a portfolio that is designed specifically for you and is rebalanced whenever it is prudent, you could invest in a managed portfolio, taking the administrative responsibilities and time commitment off of your shoulders. Your allocations could then be rebalanced for you whenever it makes sense for your financial plan and in the right manner according to your priorities. Rather than attempting to determine set intervals to review your portfolio, you would gain the ability to take advantage of potential opportunities in real time. By investing in a managed portfolio with BFA Wealth Management, you can make choices like these together with a dedicated financial partner, and instead of constantly monitoring and evaluating your investments, you can spend your time focusing on what matters to you most. When it looks like a good time to rebalance, we’ll give you a call to discuss your options.

If you're starting to wonder about your current portfolio – even if you feel comfortable but wouldn’t mind a second opinion – I’d love to hear from you. We're currently offering complimentary portfolio analysis, complete with risk tolerance assessment and allocation review, to help individuals with $250,000 or more of investable assets understand their options and compare their investments to their goals.  If you'd like to have us take a look, free of charge and with no obligation, get in touch with us today. Let’s talk.

All the best,

Mateo

 
 

Mateo James Dellovo is a private wealth advisor, financial planner, and C.E.O. of BFA Wealth Management