With share prices having run hard, now could be the time to seal some profits and ensure your holdings meet your portfolio needs. Becoming overweight the winners may expose your portfolio to greater risk and leave you disappointed by a market correction.
Rebalancing helps you reduce risk without compromising on your savings goals.
Here are some insights.
Scott Keeley, senior financial adviser with Wakefield Partners.
Typically, portfolios are established with quite strict parameters. Ensuring that the portfolio stays as close as possible to these parameters is important to avoid unexpected outcomes, particularly during market downturns.
Diversification is key and allowing a few holdings to become overweight in a portfolio can expose the entire portfolio to greater risk.
When the size of the investment becomes nuisance value in comparison to the broader portfolio, it’s probably time to say goodbye.
It is important to remove emotion and remember why the specific investments were purchased in the first place.
While selling winners may be hard, selling losers can be even harder. Again, this is as much about emotion. It is hard to let go and essentially admit defeat in one of your investments. It is also important to define ‘loser’ and again to remember why the investment was purchased.
A fall in capital value, while it can be depressing, does not make an investment a loser. If the investment was purchased for a regular, sustainable income, and that remains intact, then perhaps it is not a loser. The odd loss can be handy to offset hopefully other capital gains, but no one sets out to make a loss.
Capital gains and losses is only one component of portfolio rebalancing. I’d argue that the risk of being invested out of your alignment of your risk tolerance outweighs the tax considerations.
Stan Shamu, senior portfolio strategist with Crestone Wealth Management.
Rebalancing takes the guess work out of investing and ensures we stay the course with our long-term strategy.
Failure to rebalance can threaten the diversification benefits of a portfolio. It is best practice to set limits or ranges around how far the actual asset allocation can drift from the target asset allocation, the latter being linked to an investor’s risk tolerance levels.
The first layer being the strategic asset allocation ranges, which are generally hard limits and stipulate a wide range for the asset allocation. For example, an allowable strategic asset allocation range for equities could be 0 to 60%.
The second layer, which is more applicable in this case, is around tactical asset allocation ranges. Typically, this entails stipulating a maximum and minimum range the actual asset allocation can drift away from the tactical asset allocation.
For example, a plus-or-minus 3% range for an asset class is a reasonable and practical point to commence the rebalancing process without being too reactive.
In risk-off environments, portfolios tend to be overweight cash, bonds and alternatives, while underweight equities and credit.
Christine Benz, director of personal finance with Morningstar.
Rebalancing is a disciplined way to make sure your portfolio’s risk level remains in check.
In contrast with market-timing, which can involve dramatic, “you’re in or you’re out” shifts among asset classes, rebalancing means that you’re making changes only to bring its allocations back in line with your plan.
The main virtue of rebalancing is in the realm of risk reduction. Several studies indicate that portfolios that are periodically rebalanced back to a target asset mix have lower risk levels than portfolios whose risk levels are never adjusted.
Rebalancing at the asset-class level will have the biggest impact on how your portfolio behaves. But it’s also possible to rebalance within asset classes. If growth stocks have outperformed dramatically, you’d peel back on them and add to value names. If pharma stocks have outperformed, you’d cut back on them and add to other sectors. A person who’s rebalancing within the equity portion of her portfolio is periodically cutting exposure to a more expensive asset class in favour of a more favourably valued one, it stands to reason that this type of rebalancing has more potential to enhance returns than does rebalancing at the asset-class level.
You can engage in both types of rebalancing at the same time. For example, if you’ve determined that you need to cut back stocks and you’d also like to restore your portfolio’s balance of growth and value exposure, you can adjust your asset allocation by selling growth stocks/funds and moving the money into bonds.
When to rebalance?
Even investors who are sold on the merits of rebalancing often struggle with how often to do it. Here is some guidance.
- Stan Shamu, portfolio strategist: A quarterly review and rebalance in normal market conditions. But in periods of heightened volatility, more frequent rebalancing may be required.
- Scott Keeley, financial adviser: An annual review and rebalance: Much more than this, and transaction costs can mount up. Less than this, and the risk of unexpected outcomes is greater.
- Mahesh Mirpuri, AMFI-registered mutual fund distributor: An annual rebalance, only if required. If the market has run up tremendously, or beyond a level you expected, you can rebalance even if a year has not yet passed. Many large investors I know fix the level at 15% intra year. On the flip side, if you resort to it often, you can miss big moves. Nothing is written in stone. It is very individualistic and personal. Fix a process. Fix your own level.
- D Muthukrishnan, Certified Financial Planner: I view it very differently. During earning years, other than the Emergency Fund and money needed for short term goals, I'm for 100% equity.
You have to make your own call. Whatever you decide upon, follow it and stick to it.
Morningstar.com.au contributed to this article.