Let’s talk about portfolio rebalancing.
For those of you who aren’t familiar, portfolio rebalancing is simply adjusting the amount of your current investment holdings to maintain a target investment mix, or asset allocation.
Let’s say you have 2 investments:
- Investment A
- Investment B
According to your financial plan, which takes into account your current and future anticipated financial resources and looks at how likely it is that you can accomplish your goals and support your lifestyle for the rest of your life, you should have arrived at a target investment portfolio mix.
An investment mix that provides sufficient comfort and confidence that you can, with some adjustments along the way, stay on track to live your life in the manner you want to.
Preferably this mix is among different asset classes that are well diversified and that don’t move in the same direction at the same time. This is also referred to as having “low correlation.”
So, back to our sample portfolio of investments A and B.
Let’s say our target investment mix is 50% A + 50% B.
However, keeping this mix constant can be a challenge because of:
- Market fluctuations
- Portfolio additions (saving)
- Portfolio withdrawals (spending)
Let’s look at each one in just a little more detail…
Regardless of what types of investments A and B represent, their prices will change.
If you start with a 50/50 mix, and A’s price goes up, you’ll know own more of A relative to B, at least in dollar terms.
But what if A’s price doesn’t change, but B’s price falls?
Again, you’ll now own more of A than B.
This can create risk management problems, because as you get too far away from your target mix of 50/50, you’re taking on more risk because you now have a higher exposure to one investment relative to the other.
In both of the examples above, if you find yourself with more of investment A than B, the simple solution is to sell a little of A and buy a little more of B such that you get back to your target mix of 50/50.
And yes, this could create a tax liability, but better to pay taxes on a gain than watch your portfolio potentially lose a lot more because your invesment risk got out of whack.
Here it is in dollar terms…
You own $1,000 of investment A and $1,000 of investment B.
If investment A goes up by 5%, it’s no worth $1,050. If your balance in investment B is still worth $1,000, you now own a little over 51% in investment A and a little less than 49% of investment B.
To rebalance, simply sell $25 worth of investment A and use it to buy $25 of investment B.
Now your portfolio is worth $2,050 with $1,025 in A and $1,025 in B.
You’re back to a 50/50 investment mix.
Of course, this is always in flux to some degree or another.
Another way to rebalance your portfolio is with deposits, or savings, into your account(s).
Using the example above where A goes up $50, rather than selling some of A to buy more B, you could instead add $50 to the portfolio and invest all of it into B.
Now your portfolio is worth $2,100 with $1,050 each in A and B.
Once again, back to 50/50.
And there’s no exposure to potential capital gains in this scenario because we didn’t have to sell anything.
However, if you’re just automatically buying an additional $25 of investment A and $25 of investment B each month, your portfolio will almost certainly drift from your target mix.
Using portfolio withdrawals to rebalance your investments is the portfolio additions technique in reverse…
If you need to take money out of your portfolio and A is now worth $1,050 and B is worth $1,000, you could just sell $50 of A and use it for spending needs.
This results in a portfolio with $1,000 each in A and B and you’ve gotten $50 out of your portfolio for spending or lifestyle needs.
But be aware that this could create potential capital gains when you sell investment A. So while you took out $50 “gross,” your “net” (after-tax) income might be less.
And just like in the example about portfolio additions above, if you’ve setup automated withdrawals from your portfolio where you’re pulling $50 per month out of your portfolio – $25 each per month from A and B – again, you’ll drift away from your target investment mix over time.
The above are just a couple of ways to keep your portfolio (and risk) in balance. Despite market fluctuations and cash flow into and out of your portfolio.
There are a lot of approaches and perspectives on how often you should rebalance or when the best time to rebalance is, but maybe we’ll tackle that in another newsletter.
Yet another benefit of this approach is that it creates a disciplined way to incrementally “buy low and sell high” which is the opposite of what most investors tend to do.
By taking small profits when an investment is up and reinvesting it into another relatively lower priced investment, you’re literally selling high and buying low.
And with all the ups and downs we’ve seen in the market over the last couple of months (thanks again Covid-19), portfolio rebalancing works both ways.
When the market was falling in late February and March, my portfolio management team was rebalancing my clients’ portfolios by selling a little of our bond fund – which were up in price relative to stocks – and buying a little more of our stock fund(s) which were less expensive relative to bonds.
More recently, as stocks have generally been going up since late March, my portfolio management team has been selling some of my clients’ stock fund(s) and buying more of their bond funds as the market has been rising.
Again, rebalancing works both ways.
Naturally, you might be asking yourself, why not just leave the money alone and “let it run” while stocks are going up?
And yes, that would be a great strategy…
If you have a fully functioning crystal ball and can see the future.
Since no one can predict the market, portfolio rebalancing is the smartest way to manage your portfolio and your investment risk while incrementally selling high and buying low in all types of market environments.