Equius Principles: Portfolio Rebalancing

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Once your asset mix is established and we’ve selected the best investment vehicles to accomplish your goals, it is our responsibility to maintain that asset mix through time as markets move up and down and you add capital to or withdraw it from your portfolio. 

This portfolio “rebalancing” is an important form of risk control, since each asset class has its own risk/return profile. Managing this risk properly increases the probability of achieving expected investment outcomes and results in a more stable portfolio and overall investing experience. 

Equius clients regularly add to their portfolios while they’re working and saving (or perhaps from an inheritance or other source) and withdraw funds for major purchases or during retirement to meet everyday expenses. 

As cash flow events are planned, your advisor will be communicating with you to understand the timing and amounts of each and will rebalance the portfolio in the most cost-effective way—always considering transaction costs and especially tax consequences for taxable portfolios. 

This is why portfolio rebalancing should never be put on automatic pilot using either a time-based system or tolerance bands (deviation from targets). Many portfolio management software programs allow advisors to set a fixed rebalancing scheme for all or certain subsets of their client base (typically differentiated between taxable and nontaxable portfolios). This creates inefficiency in at least two areas. 

First, this impersonal approach ignores the potential for cash flows into or out of the account. If you add assets on June 15, for example, and we use those funds to put your portfolio back in balance, an automatic rebalancing on June 30 is almost certain to create unnecessary transactions, depending on the degree to which markets moved over those two weeks. 

Second, and more importantly, a too-frequent rebalancing system will “cut your profits short” in the higher-risk asset classes (stocks in general and small-cap and value stocks in particular) with very little meaningful effect on portfolio risk. This is due to the fact that these asset classes with higher expected return have momentum—they tend to go up more than they go down and to degrees worth capturing for as long as possible. 

Investors who can tolerate more “tracking error” in their policy allocations have the potential to earn higher returns as a result. This potential for higher returns depends on the asset class mix and the particular market environment we’re in. As a result, backtesting past performance offers us little insight. 

The Lazy Advisor Issue 

I believe the largest potential cost of rebalancing for clients is choosing an advisor who puts his/her needs ahead of portfolio optimization. These advisors typically choose an automated quarterly rebalancing methodology offered by their software vendor in order to avoid the hard work that personalization involves. Push a button and Blinky the Computer does the rest. 

There’s also this need among some advisors—fueled, I believe, by personal insecurity—to look like they’re “doing something” (creating more transactions for your monthly statement) rather than focusing on keeping costs as low as possible, mitigating tax consequences, talking with clients about future cash flows into and out of the portfolio, counseling against unproductive behavior, and letting markets (asset classes) work. 

Fortunately for Equius clients, our advisory team does not avoid hard work or suffer from insecurities about our investment strategy. 

For another perspective on this topic, please read Dimensional’s new research here. 

Equius Partners, Inc. is a Registered Investment Advisor.

Past performance is not a guarantee of future results. The data and information set forth herein are provided for educational purposes only and should not be considered tax, legal or investment advice; a solicitation to buy or sell securities; or an opinion on specific situations – as individual circumstances vary. There is no guarantee an investing strategy will be successful. Investing involves risks, including possible loss of principal. Diversification does not eliminate risk, including the risk of market or systemic loss.

Please consider the investment objectives, risks, and charges and expenses of any mutual fund and read the prospectus carefully before investing. Indexes are not available for direct investment; therefore, their performance does not reflect the expenses associated with the management of an actual portfolio.

© 2023 Equius Partners, Inc.

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