Staying Balanced

A recent article in the Wall Street Journal addressed the issues of rebalancing a portfolio to its target asset allocation.  The relatively brief article was on point, but did not address the decision-making matrix required to properly execute investment portfolio rebalancing.  It is a complex process which requires knowledge, patience and software to manage wealth.

Everyone should have a comprehensive asset allocation which is applied to their overall financial situation.  Your asset allocation is driven by your risk tolerance.  Those who have higher tolerance for risk have a higher allocation to stocks.  Low risk tolerance translates into a higher allocation to bonds. 

Once your risk tolerance is determined, the asset allocation should be applied to all of your accounts–regardless of where the account is.  It doesn’t work to apply an asset allocation to your 401(k) account and then a different one for your spouse’s IRA.  Everything must be viewed in the aggregate.  If you have accounts in lots of different places, it’s hard to get the “big picture.”  You need software to capture all that data at any given time to see your current asset allocation to determine if changes are required.

Rebalancing doesn’t increase return; it manages risk.  Since your asset allocation is based on your risk tolerance, it is not based on expected return.  Adopting a rebalancing policy forces you to sell assets with good returns and buy assets with poor returns.  Does this sound like sell high, buy low? 

Behavioral economics teaches us that when we manage our wealth by emotions, we tend to sell low and buy high.  We buy stocks after they have gone way up; only to watch them fall, then sell, only to see stocks go up again.  Afterward, we wish we had sold high and bought low.  We do just the opposite what we should do.  Rebalancing mitigates this problem in human behavior.  Rebalancing forces you to harvest gains and to reinvest into the original asset allocation.

The Morningstar software we use for our clients is amazing.  It permits us to take an “x-ray” of a portfolio which even shows us the cash, bonds and stocks inside mutual funds!  If a client portfolio contains individual stocks and various mutual funds along with cash, we can accurately compare the portfolio to its target asset allocation. The report provides, in percentage terms and dollar terms, where the portfolio is over or under its target.   And the software keeps track of every transaction, so we are able to determine the tax implications of rebalancing the portfolio.

Rebalancing is great for your finances because it manages risk.  Rebalancing is hard for advisors because it is hard to execute.  Properly done, rebalancing requires a comprehensive view of all your wealth, understanding tax consequences of making changes, examining the costs of making changes and deciding when to make a change.  It is hard work.  But it is important.  Probably the second most important decision you need to make to manage your wealth.