Successful Rebalancing Starts with a Goal

Goal Planning

Successful Rebalancing Starts with a Goal

Philanthropists seek more than just a tax deduction; they want to know that their donations will yield results.

November 18, 2014

“Set it and forget it” works for those as-seen-on-TV rotisserie commercials, but not when it comes to setting the asset allocations in your investment plan. Unfortunately, many investors take that stance, deciding early on how much they’ll invest and then neglecting to revisit the percentages they’ve allocated to each asset class.

That hands-off approach can take a toll on performance and how much risk you’ve taken on. Studies have shown that asset allocation is one of the most important factors in determining both the return and the risk of an investment portfolio. For example, if your portfolio is split equally between stocks and bonds and then enters a bull market for equities, the stock side of your portfolio may become disproportionately large. As a result, you may lose the built-in benefits of asset allocation. How then can you determine the optimal allocation to achieve your financial goals and how will you know when it’s time to rebalance?

Finding a target
When you first started investing, chances are you filled out an Investment Policy Statement that indicated how much risk you were willing to take on to achieve your financial goals and how much time you have until you need the money from your investments. These questions were intended to define your risk tolerance and your time horizon. Your answers determined what percentage of your investable assets should be allocated to stocks, bonds, cash and other investments. You likely also documented your goals. From there, you and your advisor set a target allocation. If you prefer to adjust your portfolio periodically, put it in writing. You’ll also want to record how far you’re willing to drift from your original allocation before resetting your portfolio.

It’s also a good idea to update that policy statement as your priorities change. In your youth, you might have been willing to take on more risk if it could lead to higher returns. If you’re older, you have a shorter time horizon as you edge closer to retirement or you may be more risk averse after the recession. Even after you’ve already established an allocation that works for you, it makes sense to revisit the percentages at least once a year to ensure they’re aligned with your current goals.

What should you do if they aren’t? That’s where the idea of rebalancing comes in to help keep your portfolio on track. While all investing involves risk and there’s no guarantee of success, a disciplined process around asset allocation could help your portfolio grow over the long term and manage how much risk you’ve taken on.

Why rebalancing matters
There are basically three ways to rebalance your portfolio: periodically at set intervals of time, say quarterly or annually; as needed, when one asset class strays too far from its original allocation; and within sub-classes, such as sectors, style or company size. Imagine for a moment that you started your portfolio evenly split between stocks and bonds. A bull market pushes your stock allocation up from 50% of your portfolio to 74%. Great, right? That means your stocks have had a strong run, while your fixed income holdings lagged. If you didn’t rebalance your portfolio periodically, it also means your account has strayed significantly from the original 50/50 allocation. As a result, your assets could be exposed to heavy losses during a subsequent bear market.

Asset allocation is the process of balancing risk and reward by combining asset classes such as stocks, bonds and cash in order to meet your goals. Each asset class responds differently to market changes. Studies have shown that the asset-allocation decision is one of the most important factors in determining both the return and the risk of an investment portfolio.

Careful consideration is required to determine how much you should allocate to each type of investment.

Another way to rebalance your portfolio is within styles (e.g., growth, value), sectors (e.g., financials, healthcare, technology) or company size (e.g., small- or large-cap). For example, if you’re a more aggressive investor who prefers to invest the majority of your assets in small company growth stocks, you might notice that a market that favors large cap stocks could push your portfolio to be more conservative than you’d like. Rebalancing should bring your portfolio back in line with your more ambitious objectives.

Factors to consider
Keep in mind that changes to your allocation will mean buying and selling securities for your portfolio, which could incur capital gains taxes and trading costs. So it’s wise to do any rebalancing in light of overall benefit to the portfolio, considering enhancements to performance, costs and any potential tax liability.

Reducing your tax burden
Consider reallocating your portfolio to include more tax-advantaged investments, such as municipal bonds or dividend-paying stocks, especially in higher tax brackets. Also consider using new money coming into the account versus selling off certain investments to avoid incurring unnecessary capital gain taxes.

In addition, consider that outperforming asset classes tend to do so for a number of years. If you prefer, you can rebalance as needed, say when one asset class reaches 150% of its original allocation. That way, you benefit from strong momentum in that area of the market, while periodically adjusting to avoid overexposure to a certain asset class or sector.

Getting disciplined
Any market movement will alter the risk and performance characteristics of your holdings so that your portfolio no longer aligns with your original intentions. It may sound counterintuitive to cut back on investments that have done well in favor of those that haven’t. However, over the long run, your portfolio may grow more consistently as rebalancing prompts you to buy low and sell high, while bringing your portfolio back in line with your financial priorities.

Before taking action, you may want to consider setting a discipline around asset allocation and rebalancing. This is a core tenet of many institutional investors whose investment mandates build in automatic rebalancing. They’re less likely to allow overconfidence to let winners run for too long or allow the asset mix to diverge too far from their original intentions. Individual investors, however, may prefer to establish flexible rebalancing guidelines instead of hard-and-fast rules, so you can consider taxes, trading costs and your objectives before making changes. Be aware that significant market volatility, lopsided portfolios and major life events are reason enough to take another look at your asset allocation.

Asset allocation does not guarantee a profit nor protect against loss. Investing involves risks including the possible loss of capital. Technology and small-cap investments involve greater risks. Dividends are not guaranteed and will fluctuate. While interest on municipal bonds is generally exempt from federal income tax, it may be subject to the federal alternative minimum tax, or state or local taxes. Profits and losses on federally tax-exempt bonds may be subject to capital gains tax treatment. In addition, certain municipal bonds (such as Build America Bonds) are issued without a federal tax exemption, which subjects the related interest income to federal income tax.

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