News & Commentary

The juggling act of balancing a portfolio 23 Jul 10

Balance is something we often aspire to but fall short of achieving both in life and investing.

And for investors the concept of “rebalancing” a portfolio can seem like commonsense on one level and completely counterintuitive on the other.

Let’s start with the understanding that your asset allocation decision – which takes into account your risk tolerance, time horizon and financial goals – is the most important decision in building your portfolio.

Once you have got the mix set between local shares, international shares, property, fixed interest and cash and the portfolio invested accordingly that will determine the portfolio’s risk and return.

But of course markets – and investment values – do not stand still so rebalancing to your target allocations will be important in order to keep your portfolio in line with your risk tolerance.

So along with your investment strategy it pays to think about how often you are going to rebalance the portfolio – and the triggers involved.

Keeping a portfolio within your tolerance levels is the bit about rebalancing that has people nodding their heads in agreement at what appeals as a commonsense approach. However, the practical impact of rebalancing – and what makes it so hard for individual investors – is that if you look back now on the global financial crisis and ask yourself would you have been prepared to sell your best performing assets (think property or fixed interest) and buy more of the underperforming assets (shares)? Given the uncertainty that was the hallmark of the GFC it is not surprising that investors would have struggled with that concept after share markets had plunged around the world.

The GFC clearly was an extreme market event so consider it from a different perspective: Australian investors had a stronger, longer love affair with listed property trusts than almost any other asset class in the mid 2000s. As we now know ultimately that debt-fuelled party ended badly. But if investors in that asset class had rebalanced regularly they would have significantly reduced the risk that built up inside the portfolio as values rose.

So rebalancing a portfolio is about minimising risk rather than maximising returns.

Vanguard’s research team in the US has just completed a research project into best practices of portfolio rebalancing and looked back at US investment markets over a long period of time from 1926 to 2009.

When you transact your portfolio there are real world costs; plus taxes and your time.

There are two key questions when considering your rebalancing strategy: how often – monthly, semi-annually or annually – and what triggers the rebalance. For example do you rebalance when a particular asset class moves 1% othe desired range or 5% or>

In many ways this is an argument for a diversified managed fund because the rebalancing piece is built into the fund manager’s function.

But many investors and advisers like the portfolio control that comes from sector or direct investments.

The research study tested three rebalancing strategies:

• Time-only where the portfolio is rebalanced every day, month or year regardless of how the portfolio has drifted from its target asset allocation.
• Threshold-only where rebalancing is triggered only when a threshold change to a portfolio has occurred. That is when rebalancing is triggered only when the portfolio’s asset allocation has drifted more that a certain amount – be it 1%, % -rom the original target asset allocation.
• The final strategy was a combination of both – time and threshold. This is where a portfolio is rebalanced on a set time schedule but only when its asset allocation has drifted away from the target asset allocation by greater than the threshold amount.

For example if an investor chose to rebalance the portfolio – defined as a hypothetical 60% snd 40% btfolio – each month over the past 80 years it would have meant 1008 rebalancing events. If the rebalancing was done annually and only when asset classes had moved outside a 10% td it would have required only 15 rebalancing events.

Like most things rebalancing requires a trade-off. In this case it is between tightly tracking your asset allocation versus the tax and transaction costs.

The study concluded that for most broadly diversified portfolios annual or semi-annual rebalancing with a 5% td produced a reasonable balance between risk control and keeping costs low.

* Written by Robin Bowerman, Head of Retail at Vanguard Investments Australia.
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