Imagine you just bought a new car. You love how it looks and handles. You take it on long, beautiful drives together. When you take your car in to be serviced, you are asked if you want the tires rotated. You’re a bit baffled because the car seems to be handling just fine. The service manager explains that tires tend to wear unevenly and that rotating them will extend their life. You agree to this service and your tires are moved around the car in a square dance pattern.
A diversified investment portfolio is similar. There are times when certain areas of your portfolio wear better than others. You can find a recent example of this in the first quarters of 2018. US Large Cap equities were on a steep incline, while International equities experienced a slump. A portfolio that went unchecked would find that after a period of positive performance, the portion allocated to US Large Cap stocks may have grown higher than what the investor originally intended, due to this growth. To fix this, you move some assets to other areas of the portfolio to bring it back inline. This is called portfolio rebalancing, and it is usually in response to market movements. Portfolio rebalancing seems counterintuitive because you are selling those assets in your portfolio that are doing well (like the US Large Cap in our example above) to buy those that are not doing as well (like the International equities above) in order to stay diversified. It is a disciplined way to “buy low and sell high” and it’s key to spreading your investment risk across more than one asset class.
Several months later you take the car in to be serviced and this time, instead of asking if you want to rotate the tires, you are asked if you want to put on studded tires. The service manager explains that the seasons are changing and you will want to be prepared for the upcoming months. You agree and the tires are exchanged.
Unlike portfolio rebalancing, which brings it back to your original intention, portfolio reallocating is akin to making changes based on the season of your life. These seasons include the normal human experiences such as a new graduate, young family, empty nesters and retirement, as well as life events such as marriage, divorce, career changes, and “Whoa the horses! The markets are crazy and I just realized that makes me panic!”
When and how to rebalance
Portfolio rebalancing is typically done in one of two ways. One is based on time. The other is based on variance. The time approach sets a schedule for rebalancing (quarterly, semi-annually or annually). The variance approach triggers a rebalance when the current portfolio is a certain distance (measured in percentage points) from its target.
For “do-it-yourselfers,” setting up a rebalance based on a recurring schedule is the easier of the two. Many investment firms have several options to automate this. Setting up a rebalance based on variance is more complicated and may not be available with all investment firms.
An alternative to rebalancing is to utilize a “balanced ” fund or a “lifestyle” fund . These funds are typically a predetermined mix of asset classes and are adjusted regularly by the fund managers. Rather than needing a number of mutual funds from individual asset classes to make up a diversified portfolio, investors can choose one of these types of funds as a ‘one stop shop.’
When and how to reallocate
When to reallocate your portfolio is much like going back to the proverbial drawing board. It means taking an honest inventory of your goals, your resources and your tolerance for market volatility. It may include taking a risk assessment again or for the first time. It is asking yourself “Has anything changed or become more imminent since I originally chose my investment strategy?”
After going through this process you may find that it is time to change. Maybe you’ve retired and have begun drawing on your investments for income. Often, this means moving to a more conservative mix of investments. Maybe the goal you were saving for has been funded and you don’t have an upcoming need to tap your nest egg. That might drive you to become more aggressive. If doing it yourself, it usually means logging onto the investment firm’s website to create a new mix of investments that better reflects your current investment strategy.
How we handle rebalancing and reallocating
Since portfolio rebalancing tends to be objective, our team of advisors trust the experience of our investment management committee, who follow a well-defined rebalancing plan based on variance.
Reallocation is a very different story. It is based on the personal relationships we have with our clients. Ongoing conversations to discuss changes in life circumstance and goals, coupled with our professional experience can help determine when and how to reallocate. We consider it a privilege that our clients invite us to share in the seasons of their lives – the warm along with the cold, times of new growth and times of dormancy.
If you have any questions regarding the care of your nest egg, we invite you to contact our office. In portfolio design, rebalancing and reallocating, we take an in-depth look at the unique and changing needs of our clients.