Over the last couple of weeks, Prime Capital Investment Advisors have been rebalancing our clients accounts. These seemingly small transactions of buys and sells happening inside your portfolio may often be overlooked by clients as to their importance. So, I thought I’d take a minute to discuss both the reasoning and importance of a typical portfolio rebalance.
Most investors begin their investment journey by choosing a level of risk. Choosing how much exposure to the volatility of the stock market you are comfortable with is crucially important. If you haven’t determined your risk tolerance in a while, click here.
Let’s say for the purpose of this thought experiment, you choose a moderate level of risk with 60% of your money in stocks or stock mutual funds for growth and 40% of your money invested in bonds for stability. After a year, the stocks in your account have grown by 20% and bonds have stayed relatively unchanged. Ignoring fees, dividends and interest for the moment, is your portfolio still the moderate risk level that you started out with? No. The stock portion of your account has grown to approximately 72% of your account (60% plus 20% growth or 12%) and bonds are now only 28% of your account.
By rebalancing your account at this point, you reset your balance back to 60/40 by selling shares of your stocks (theoretically at a relative high point) and buying more shares of bonds. Now assume a 10% correction comes along. Assuming you had a $100,000 account, you reduced the amount of potential loss in your account by $1,200.
The reverse is true as well. Turning our attention to the correction begun in January of 2022, our moderate investor may have started the year at 60/40 and now find themselves at 54% stock (roughly 10% correction) and 46% bonds. Assuming that what goes down eventually goes back up, let’s say that the market rallies 20% from these levels and so does our investors’ stock funds. The investor who chooses to rebalance may see their account go up more as a result of the rebalance.
While the balance between stocks and bonds is important, a well-diversified portfolio will contain companies of various size or market capitalization. By owning mutual funds that contain large capitalization or “cap” for short, along with mid cap and small cap stocks will provide exposure to companies in various stages of their lifecycle. These stocks don’t all go up or down at the same time or rate, therefore this balance can fall out of alignment as well. Again, over the last few months, it has been large technology companies that have been hit harder during this correction. By rebalancing you may be adding to stocks that now are trading at a better price or value to what they were prior to the correction.
A Matter of Style
Stocks or stock funds are also categorized by style. A properly constructed portfolio has room for both. (See Growth vs. Value Investing: Understanding the Differences) Often, these styles will work in opposite direction of each other and will also need rebalancing.
Many people have heard of the Periodic Table of Elements, but not many have heard of the Periodic Table of Investment Returns produced by Callan, which graphically depicts annual returns for various asset classes, ranked from best to worst. From month to month or year to year, you can see a rotation among the different asset classes discussed above and showing how rebalancing keeps you properly aligned to your model.
It’s All in the Timing
How often should you rebalance? That’s a matter of opinion. Some firms rebalance or recommend to on a fixed schedule such as quarterly, semi-annually or annually. Known as calendar rebalancing, it is convenient but may not maximize the effect of risk reduction or opportunity seeking you may be looking for. Others recommend looking for a certain amount of “drift” or variances such a rebalancing when your asset classes are off target by +/- 5%. This type of rebalancing is often referred to as corridor rebalancing and can have a more desired result but is more intensive.
In summary, portfolio rebalancing provides an investor protection and discipline for any investment management strategy at both the retail and professional levels. The ideal strategy will balance out the overall needs of rebalancing with the explicit costs associated with the chosen strategy. But one factor that many point to as a reason that professional money managers typically outperform individual investors is due to a disciplined rebalancing approach. If you’re not doing it, consider hiring a pro.
The content is developed from sources believed to be providing accurate information. The information in this material is not intended as tax or legal advice. Please consult legal or tax professionals for specific information regarding your individual situation. Some of this material was developed and produced by AZELLA to provide information on a topic that may be of interest. AZELLA is not affiliated with the named representative, broker – dealer, state – or SEC – registered investment advisory firm. The opinions expressed and material provided are for general information, and should not be considered a solicitation for the purchase or sale of any security.
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