Why rebalance an investment portfolio?

Many financial decisions we make regarding our personal finances can involve a certain level of risk.

However, the level of risk that we are willing (tolerance) and able (capacity) to take, can vary from one person to the next.

This is normal, and is often due the differences that exist in our:

  1. financial situation, goals and objectives,

  2. desire to align our investment values with our personal values,

  3. expected investment performance, time horizon, and tolerance/capacity for risk, and

  4. understanding of investment fundamentals (risk/return, asset classes, and diversification).

Given this, when it comes to investing, an important initial step is to determine our investment risk profile. This is relevant regardless of our investment structure (super or non-super), or investment time horizon.

Our investment risk profile defines our chosen asset allocation. This is the weightings held within our investment portfolio with respect to the different types of asset classes:

  • defensive asset classes, such as cash and fixed interest, and

  • growth-orientated asset classes, such as property and shares.

As an example, our investment risk profile may define our chosen asset allocation as being the following:

  • 30% of funds allocated to defensive asset classes, and

  • 70% of funds allocated to growth-orientated asset classes.

As noted by the names, defensive and growth-orientated, asset classes (and their sub-classes) have their own unique characteristics. This is inclusive of their level of risk/return over the short, medium and long-term.

When considering historical data, it’s important to note that asset classes tend to rise and fall at different times depending on economic, political and market factors. This is highlighted below.

Screen Shot 2020-04-08 at 4.00.58 pm.png

These rises and falls can affect our chosen asset allocation. This is highlighted below in a simplistic example.

Screen Shot 2020-04-08 at 4.03.00 pm.png

The 2015 calendar year annual returns for asset classes has affected the chosen asset allocation:

  • Chosen asset allocation:

    • 30% of funds allocated to defensive asset classes, and

    • 70% of funds allocated to growth-orientated asset classes.

  • New asset allocation:

    • 28.4% of funds allocated to defensive asset classes, and

    • 71.6% of funds allocated to growth-orientated asset classes.

This ‘percentage drift’ can become more pronounced with time. For example, if the 2016-2019 calendar year annual returns for asset classes were also included then the following new asset allocation would emerge:

  • New asset allocation:

    • 23.3% of funds allocated to defensive asset classes, and

    • 76.7% of funds allocated to growth-orientated asset classes.

Importantly, if this isn’t monitored and acted upon accordingly when required, we can find ourselves inappropriately invested. Namely, invested with a level of risk that we aren’t willing and able to take.

For these reasons, periodically rebalancing an investment portfolio can be an important consideration. Rebalancing is the process of adjusting the existing asset allocation back to the chosen asset allocation.

The main purpose of rebalancing is to maintain our investment risk profile, not to maximise returns.

However, research* suggests that rebalancing can typically improve risk-adjusted returns, as well as help with emotional control in volatile investment markets, and the maintenance of diversification across asset classes.

There are several different types of rebalancing strategies:

  • A time trigger – whereby rebalancing occurs at a predetermined time interval, such as monthly, quarterly, semi-annually or annually.

  • A threshold trigger – whereby rebalancing occurs when an asset class moves outside a predetermined weighting tolerance range, such as +/- 5%.

  • A combination of both – a time trigger and a threshold trigger.

Also, how a rebalance is achieved can be approached several different ways:

  • by investing additional funds to replenish asset classes that are underweight, or

  • by selling asset classes that are overweight and buying asset classes that are underweight.

Important considerations

Whilst research suggests that any reasonable rebalancing strategy is often more beneficial than not rebalancing at all, it’s important to understand that rebalancing too often may incur unnecessary tax and transaction costs.

Lastly, retirees and pre-retirees can often have a lower level of risk tolerance and capacity than their counterparts, wealth accumulators. As such, they may find that they require more frequent rebalancing.

If you have any questions regarding this article, please do not hesitate to contact us.

Jenni Anderson