As we introduced in our last post, “When’s the Last Time You “Mowed” Your Portfolio?” portfolio rebalancing is a good idea for at least three reasons. Not only are you keeping your portfolio efficiently on track toward your personal goals and managing your desired risk levels, but you’re establishing a disciplined approach for buying when prices are low and selling when prices are high. Still, there are challenges to achieving rebalancing nirvana: emotions, costs and complexities top the list.
Evidence Over Emotion
Everyone understands the logic of buying low and selling high. Indeed, as Warren Buffett wrote in his 2008 Berkshire Hathaway Letter to Shareholders, “Whether we’re talking about socks or stocks, I like buying quality merchandise when it is marked down.” But when it comes to actually doing it, your emotions often get in the way.
For example, remember that Great Recession of 2007–2009? To rebalance, you had to sell some of your safe-harbor holdings – your bonds and bond funds (selling high) – and use the proceeds to buy stocks (buying low). This was really hard to do when every cell in your body was screaming at you to do exactly the opposite, and fast. On the flip side, an exuberant market can be another rebalancing opportunity, and another challenge, as you must sell some of your high-flyers (selling high) and rebalance into the recent losers (buying low).
Thus, buying low and selling high often feels counterintuitive and against your natural (emotional) instincts. Not to mention, we humans tend to put off all sorts of good ideas until tomorrow. To combat that, consider these illustrations: Those who used a rebalancing process to overcome their fear-driven instincts during the Great Recession were better positioned to capture available returns during the subsequent recovery. In contrast, those who rode the 1990s dot-com wave all the way through to its ultimate collapse learned a painful lesson about why it’s a good idea to periodically shift realized profits to safer grounds, before the bubbles burst.
If trading were free, you could precisely rebalance your portfolio daily. In reality, trading incurs transaction fees as well as potential tax liabilities. To strike a happy compromise, you want to have guidelines in place for when and how to rebalance.
At Pathway we apply a tolerance band of 5 percentage points. If an asset class swings more than 5 points off-target, it’s time to rebalance. For example, if we’ve planned a 10% allocation to Emerging Markets stocks, we rebalance if the allocation wanders to less than 5% or more than 15%. This keeps the portfolio relatively on track while minimizing hyperactive trading costs.
It’s also a good idea to rebalance with new money whenever possible, to avoid selling existing holdings. This works particularly well if you are still in the accumulation phase (i.e. growing your retirement portfolio). By using new money to bring your portfolio back to plan, you’re minimizing trading costs, buying low, and removing the subjective guesswork. That’s a triple whammy of investment best practices!
Managing the Moving Parts
As you might imagine, it can get pretty hairy to closely monitor a family’s total portfolio across numerous asset classes and various types of taxable and tax-sheltered accounts. While each “checkpoint” in itself is not rocket science, optimized rebalancing is best achieved with the assistance of a professional advisor who is using well-designed software for dedicated portfolio monitoring and sophisticated rebalancing. The combination is a powerful way to combine the many parts into a cost-effective and tax-efficient rebalancing whole.
The Rebalancing Take-Home
Rebalancing makes a great deal of sense once you understand the basics: It gives you a clear process and cost-sensitive solutions for staying on course toward your personal goals through rocky markets. It ensures you are buying low and selling high, and managing your desired risk levels along the way. It replaces emotional guesswork with evidence-based action.
At the same time, rebalancing within your globally diversified portfolio requires both emotional resolve as well as informed oversight, to consistently and cost effectively manage the complexities. Helping investors optimize their portfolio rebalancing is another vital way we seek to add value to their investment experience. Give us a call to learn more.
For more information or to set up a consultation, contact Pathway Financial Planning at 248-567-2160 or email email@example.com.