June 14, 2016
Why you should consider active rebalancing in your portfolio versus calendar rebalancing
Questions to ask when rebalancing your portfolio to maintain your target allocation
By Nick Johnson, June 2016
Recently, I found myself speaking with clients about the benefits of a strategy we call active rebalancing, also known as opportunistic rebalancing, and how it can potentially add value to portfolio returns versus the more simplistic strategy of calendar rebalancing. We believe this is an appropriate strategy for the current market environment, which is why this is one of the many tools we employ in order to enhance our investment management style.
What is active rebalancing? As a matter of fact, what is calendar rebalancing? Why is it important to me? Before we answer these questions, let’s discuss portfolio drift. The term portfolio drift is a fancy way of explaining how the current weighting of a portfolio shifts away from its intended target due to market movement.
As an example, let’s say you have an account with the target allocation of 65% equities and 35% fixed income. Then let’s say the equity markets headed north and your initial allocation to equities morphs into 72% of your total portfolio instead of the 65%. You are now overweight in equities and unintentionally taking more risk than you prefer.
Calendar rebalancing is a simplistic methodology used to correct this phenomenon. At a set time, for instance, once a year or every quarter, you will rebalance your portfolio to the optimal allocation. This also ensures that the 72% equities do not keep growing to become 85% equities. Calendar rebalancing has the potential to increase returns in a portfolio over time since there is a tendency to sell assets that run up in value, also referred to as trimming the winners, and buy assets that lose value, also known as adding to the losers. As Warren Buffet once said, “I prefer to buy when others are fearful, and sell when they are greedy.”
Why do we prefer active or opportunistic rebalancing better? When using this strategy, trades are placed to rebalance the portfolio as soon as the portfolio gets far enough away from its target allocation. To correct the above example using this strategy, you may rebalance your portfolio as soon as it hits 75% equities, which would be 10% away from the ideal allocation of the 65% equities.
Over time, you are more likely to sell the winners and trim the losers at a better price when using the active rebalancing strategy compared to calendar rebalancing because active rebalancing does not force the portfolio far enough away from the target allocation. Therefore, the timing of placing trades in calendar rebalancing is more likely to be suboptimal since the portfolio is only reviewed at predetermined intervals. Opportunistic Rebalancing remedies this situation by waiting until the portfolio allocation is stretched far enough away from the ideal allocation to necessitate a rebalance.
For further reading regarding opportunistic rebalancing, click here to read an article by Gobind Daryanani’s, CFP®, PH.D. that appeared in the Journal of Financial Planning.
Why do we believe active rebalancing make sense right now? Over and above the standard returns benefits Daryanani modeled, we believe this strategy will add additional value to returns during periods of increased volatility. Since we currently see ourselves in a slow grind up in this current volatile market period, we believe opportunistic rebalancing is an appropriate strategy. This is because since there are more highs and lows in a market there are more opportunities to buy low and sell high.
The information provided is not intended to be a substitute for specific individualized tax, legal or estate planning advice. Individual situations will vary. We can assist you in making informed decisions. No single solution meets all investor’s needs. Investing involves risk including the potential loss of principal. No investment strategy can guarantee a profit or protect against loss in periods of declining values.
Nick Johnson, CFA®, CFP®
Nick Johnson believes that financial planning is more than numbers on a balance sheet and a standardized process. People are unique and should be treated as such.
As Vice President and a Wealth Manager at Willis Johnson & Associates, his goal is to really get to know his clients, all the while providing a proactive approach to comprehensive wealth management.