Wayne Anderman is the founder, chief executive officer and wealth advisor of Anderman Wealth Partners.
In the ever-changing world of investing, maintaining a balanced portfolio can feel like trying to hit a moving target. Yet, this balance is crucial for achieving long-term financial success. Even with meticulous planning, market fluctuations can disrupt your initial asset allocation, making portfolio rebalancing essential. As a financial advisor, my goal is to help clients understand various rebalancing strategies and make informed decisions to keep their investments aligned with their goals and risk tolerance.
What is portfolio rebalancing?
Portfolio rebalancing is the process of realigning the weightings of a portfolio’s assets to maintain the desired level of asset allocation. Over time, market movements can cause certain assets to perform better than others, causing the original allocation to drift. Rebalancing ensures that the portfolio’s risk and return characteristics remain consistent with the investor’s objectives.
Why is rebalancing important?
1. Risk Management: Without rebalancing, a portfolio can become overweight in higher-risk assets, increasing overall risk.
2. Return Optimization: Rebalancing can help capture gains from outperforming assets and reinvest them into underperforming ones.
3. Discipline: Regular rebalancing enforces a systematic approach to investing, reducing the influence of emotional decision-making.
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Approaches To Rebalancing
There are several approaches to portfolio rebalancing, each with its advantages and considerations:
1. Calendar-Based Rebalancing
This approach involves rebalancing the portfolio at regular intervals, such as quarterly, semi-annually or annually. It is simple and easy to implement, however, it may lead to unnecessary transactions and costs if the portfolio hasn’t drifted significantly, potentially missing optimal rebalancing opportunities.
2. Threshold-Based Rebalancing
Threshold-based rebalancing occurs when the allocation of any asset class deviates from the target by a predetermined percentage, such as 5% or 10%. This method is responsive to market movements, potentially reducing transaction costs. However, it requires more frequent monitoring of accounts and frequent market swings can trigger rebalancing, increasing costs.
3. Constant-Mix Strategy
This strategy involves continuously buying and selling assets to maintain a fixed asset allocation, regardless of market conditions. It maintains a constant risk level that can take advantage of market volatility but can be costly due to frequent trading and may not be suitable for all market conditions.
4. Dynamic Rebalancing
Dynamic rebalancing adjusts the target allocation based on changing market conditions and the investor’s financial situation. This flexible and adaptive strategy helps tailor accounts to current market conditions and needs, optimizing risk and returns. However, it can be complex to implement.
5. Tactical Rebalancing
This approach involves making short-term adjustments to the asset allocation based on market outlook and economic forecasts while adhering to the long-term strategic allocation. This can potentially amplify returns by capitalizing on market opportunities but requires careful timing and awareness, as inaccurate market predictions can significantly increase risks.
Choosing The Right Rebalancing Strategy
After discussing various rebalancing strategies with my clients, we consider the following factors to determine the best approach for them:
• Investment Goals: Long-term growth vs. short-term gains
• Risk Tolerance: Ability to withstand market fluctuations
• Time Horizon: Investment duration and liquidity needs
• Cost Considerations: Transaction fees and tax implications
• Market Conditions: Current and anticipated market environment
For example, a client seeking steady long-term growth might prefer a calendar-based approach, while someone looking to capitalize on short-term market fluctuations might favor tactical rebalancing. It’s crucial to balance maintaining the desired asset allocation with minimizing the costs and taxes associated with rebalancing.
Case Study: A Technology-Heavy Portfolio
Consider the example of one of my clients who had a portfolio heavily weighted in technology stocks. When tech stocks surged, her portfolio became unbalanced and exposed her to higher risk. Through threshold-based rebalancing, we sold some of her tech stocks and reinvested in underperforming sectors, ensuring her risk remained in check and her portfolio aligned with her long-term goals.
Implementing Rebalancing In Practice
1. Set clear targets. Establish target allocations for each asset class based on your risk tolerance, investment goals and time horizon.
2. Choose a strategy. Select the rebalancing strategy that aligns best with your financial situation and market outlook.
3. Monitor regularly. Keep a close watch on your portfolio’s performance and market conditions to identify when rebalancing is necessary.
4. Execute efficiently. Use tax-efficient methods to rebalance, such as utilizing tax-advantaged accounts or offsetting gains with losses.
Best Practices For Rebalancing
While no single rebalancing strategy is universally optimal, research indicates that some methods may generally be more effective. Vanguard’s research shows that annual rebalancing strikes a good balance between maintaining target allocations and minimizing transaction costs and taxes. Additionally, using tolerance bands or thresholds to trigger rebalancing can be more effective than fixed time intervals. A hybrid approach combining time-based and threshold-based rebalancing can also be beneficial, offering flexibility and efficiency.
By employing a suitable rebalancing strategy, we can help clients’ portfolios remain aligned with their financial goals and risk tolerance. The key is to stay disciplined and adaptable to changing market conditions.
With rebalancing a portfolio, there can sometimes be certain challenges that arise. For instance, we had a client that let his emotional biases drive a few of his financial decisions and it ended up costing him in the long run. He had an overconfidence about a stock decision and it clouded his judgement. In these cases, I recommend having an advisor manage the process to remove emotions from decision-making.
Rebalancing is not a one-size-fits-all solution. A tailored approach can make a significant difference in achieving financial objectives. By implementing the right strategy for your unique situation, you can navigate the complexities of the market with confidence and clarity.
The information provided here is not investment, tax or financial advice. You should consult with a licensed professional for advice concerning your specific situation.
Securities offered through Avantax Investment Services Inc. Member FINRA,SIPC. Investment advisory services offered through Avantax Advisory Services Inc. Insurance services offered through an Avantax affiliated agency.
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