How does the Portfolio Re-balancing help to manage Risk and Why we have Re-balancing Strategy?
Asset allocation has been shown to be the most important factor in determining long-term investing success.(1)
Yet investors often express resistance to the idea of re-balancing their portfolios. One of their most common objections: Why sell the winners and buy more of the assets that have less impressive returns? Why not do the precise opposite to reap maximum returns?
Volatile financial markets, events in your life, and even regular investment reviews can prompt you to wonder why we (advisors) re-balance your portfolio. After all, if your strongest-performing assets account for a larger portion of your holdings, why not let them ride? It all comes down to risk, appropriately balancing risk and returns. When an advisor initially drew up your investing plan together, they weighed several factors: Your income, age, and your financial goals, among other things. We built your portfolio based on your unique goals and incorporated some market-return assumptions. The resulting portfolio’s allocation balances the potential returns you’ll need to reach your goals with the risk of potential losses you may incur. In other words, the purpose of re-balancing isn’t to score the maximum returns possible. The purpose is to manage risk, so your nest egg might fluctuate less in the event of a downturn. The chart below visualizes the concept. Historically, as the percentage of equities in a portfolio has increased, so have the portfolio’s returns. But there’s a trade-off: the higher the percentage of stocks, the greater the risk of losing money.
Historically, higher-return assets have brought increased risk
Best, Worst, and Average Returns for Various Stock/Bond Allocations, 1997-2019
Best, Worst, and Average Returns for Various Stock/Bond Allocations, 1997-2019
One way to think of it: Imagine you’re a baseball manager looking to put together a team. You have a limited number of slots and a finite budget. You could go with a big-name slugger who hits lots of home runs—and commands a hefty contract. Alternatively, you could use that same budget amount to pick up a few less flashy players—who happen to be really consistent at hitting singles and doubles. Your analysis shows that having a player with a higher on-base percentage in the lineup equates to more wins than having a player with a lot of homers. You could also reduce your risk by spreading out the investment over a few “quality” players rather than just one. So it makes sense for you to sign players who have the potential to get more base hits.
Similar reasoning is at work when you maintain a diverse, balanced portfolio with a disciplined commitment to an established asset allocation—for example, a portfolio made up of 70% stocks and 30% bonds. If you require relatively consistent returns (for instance, if you’re generating income from your portfolio and want that income to remain steady), bonds serve to dampen the market volatility that might otherwise disrupt steady returns.
Options for Re-balancing:
Time Only: Re-balancing on a set schedule such as daily, monthly, quarterly or annually.
Threshold Only: Re-balancing when a target asset allocation deviates by a predetermined percentage, such as 1%, 5% or 10%.
Time and threshold: Re-balancing on a set schedule, but only if a target asset allocation deviates by a predetermined amount, such as 1%, 5% or 10%.
Re-balancing can also be combined with and complement other strategies, such as tax-loss harvesting. Vanguard research shows that advisors can add appreciable value over time, through activities such as re-balancing and behavioral coaching in general.(2)
None of the major re-balancing approaches holds a distinct or enduring advantage over the others. Therefore, the most important consideration is to apply re-balancing to portfolios in a consistent and disciplined manner to give the best chance of reaching investor’s long-term financial goals.
At Map to Your Wealth LLC, we re-balance portfolios quarterly only if a target asset allocation deviates by 5% or more and during market corrections, if the asset allocation deviates by 10% or more.
Please contact us at www.maptoyourwealth.com/contact-us to schedule your initial FREE CONSULTATION. We do Business Virtual via phone or Video call also in addition to in person.
Notes: Please remember that all investments involve some risk. Be aware that fluctuations in the financial markets and other factors may cause declines in the value of your account. There is no guarantee that any particular asset allocation or mix of funds will meet your investment objectives or provide you with a given level of income. Diversification does not ensure a profit or protect against a loss. Investments in bonds are subject to interest rate, credit, and inflation risk. Investments in Stocks or Bonds issued by non-US companies are subjected to risks including country/regional risk and currency risk.
(1) Gary P. Brinson, L. Randolph Hood, and Gilbert L. Beebower, 1995. "Determinants of portfolio performance." Financial Analysts Journal 51(1):133–8. (Feature Articles, 1985–1994.)
(2) Francis M. Kinniry Jr., Colleen M. Jaconetti, Michael A. DiJoseph, Yan Zilbering, and Donald G. Bennyhoff, 2019. Putting a value on your value: Quantifying Vanguard Advisor's Alpha®. Valley Forge, Pa.: The Vanguard Group.