Rebalancing

The investment portfolio must be managed actively to address market changes and provide optimal risk-adjusted returns that achieve long-term goals within the investor’s risk tolerance.

What is rebalancing?

Rebalancing keeps your investment portfolio in line with your investment plan as the value of assets fluctuates over time.

For example, if stocks grow rapidly and the value of the stocks in the portfolio increase from 30% to 50%, the asset allocation must be restored by selling some stocks and using the proceeds to purchase other assets.

Why is it important?

Rebalancing enables the portfolio to stick to the investment objectives. 90% of the portfolio risks and returns over time are based on the asset allocation strategy.

Movements in the value of securities are often exaggerated by fleeting investor sentiment rather than underlying fundamentals. Selling securities that have grown sharply in value and buying those that have fallen in price maximizes returns by realizing profits on overvalued securities and investing in undervalued ones that promise more growth.

 Those who remain dispassionate and “buy the dip” benefit when the sentiment passes and the price recovers, avoiding bubbles or manias.

How is it done?

The most basic rebalancing strategy is based on defined time intervals—quarterly semi-annually or annually. This approach requires minimal effort as market movements are ignored between the rebalancing intervals which can reduce transaction costs.

Another approach is based on market movements to ensure that no asset category deviates beyond a defined tolerance range (e.g. +/- 10%). This addresses errors in a more timely manner but can incur higher transaction costs.

Regardless of whether rebalancing is based on time or market movements, it is generally prudent to revisit the portfolio at least once or twice a year.

Risks to consider

Not all declines are due to market sentiment. Buying assets that have fallen in value due to genuine underlying fundamentals may reduce returns.

 Depending on the jurisdiction, tax treatments may need to be considered. Some jurisdictions levy a tax on unrealized gains while others treat capital gains on assets that are held for a specified period more favorably.

Another factor is human psychology. A 1985 study of mutual fund performance by Hersh Shefrin and Meir Statman documented the “disposition effect,”[1] where investors tend to ignore timely rebalancing by holding losing stocks too long and selling winning stocks too soon, leading to negative results.

Given the above complexities, investors are advised to work with a well-informed, objective financial advisor to maximize the benefits of rebalancing against the irrationality of markets and the human mind.

[1] CFA Institute

About David M. Darst, CFA

Since January 2017, David M. Darst, CFA has served as Senior Advisor and Investment Strategist of The Family Office in New York and Bahrain. In this role, he has significantly contributed to the formulation, communication, execution, and monitoring of the company’s asset allocation, investment strategy, and wealth management activities in the Gulf region, North America, Europe, and Asia.

Following a 25-year career with Goldman Sachs in Zurich and New York, David served for 17 years as a Managing Director and Chief Investment Strategist of Morgan Stanley Wealth Management. David was the founding President of the Morgan Stanley Investment Group, and has served for three years as CEO of Petiole Asset Management AG, the Zurich-based asset management arm of The Family Office.

David is the author of sixteen books, including The Complete Bond Book (McGraw-Hill), The Handbook of the Bond and Money Markets (McGraw-Hill), The Art of Asset Allocation, Second Edition (McGraw-Hill) and The Little Book that Saves Your Assets (John Wiley & Sons), which has been ranked on the bestseller lists of The New York Times and Bloomberg Business Week.

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