Question:  

Could you discuss the reasons why and how to rebalance a portfolio?

Answer: 

Maintaining balance and conserving the right mix or allocation in asset classes and market sectors is an important part of financial planning. Investment valuations fluctuate all the time making it necessary to evaluate percentages held in each section of your portfolio on a regular basis. This discipline may assist with effectively managing assets to keep them aligned with your intended allocations. 

Markets change drifting higher and lower all the time. When these fluctuations cause more consistent and measurable deviations in values, you may want to rebalance holdings to bring them back in line. If this is not reviewed, you could find your portfolio allocation exposing you to more risk than you are comfortable with, or a mix that produces an overall lower return than anticipated. 

Market volatility and uncertainty are prevalent in response to geopolitical and economic concerns and as we anticipate how Federal Reserve policy and interest rate movements will combat inflation. The consensus is for one or two small rate increases from the Fed in the second quarter as they attempt to temper stubbornly high inflation. Market fluctuations remain relatively subdued since the so-called banking crisis, but companies and sectors with weak balance sheets and poor liquidity positions will potentially be tested as both access to and costs of capital are more challenging than in the past decade. 

Time is On Your Side

It can take a year or longer for the full effects of higher interest rates to be felt by consumers throughout the economy. Some components of core inflation, which is what the Fed uses as its gauge, are coming down more quickly than others. Owner’s equivalent rent, the largest component of the Consumer Price Index (CPI) is roughly 40% of CPI and takes longer to respond to monetary policy than do other components; causing overall inflation to remain high. Owner’s equivalent rent lags other index components by about a year because it’s determined by asking property owners how much it would cost to rent their residence rather than own it, surveying homeowners every six months. Now that the housing market has begun to cool, owner’s equivalent rent will follow, but the cool down will take time. This is one big reason inflation numbers lag policy actions. As we’ve witnessed, Fed policy has the potential to move markets. The key is to watch for trends rather than fads from the Fed. 

As a result of market ups and downs, your portfolio allocation may be significantly different than what you originally designed and implemented. If one asset class increases more than another, it will account for a greater percentage of the overall portfolio due to sheer growth. In contrast, an underperforming class will effectively decline, reducing exposure over time and present an opportunity to make additions. 

For instance, a portfolio allocation of 60% stocks, 30% bonds and 10% cash could drift from these numbers. For instance, if stocks performed better and bonds underperformed, you could wind up with a 64-27-9 mix. While not a dramatic shift, this could eventually evolve into a 67-15-8 combination over time. If your goals remain the same and this occurs, it may be appropriate to think about rebalancing. 

Regular reviews may help avoid surprises and provide opportunities to bring allocations back in line with your plan. Selling a portion of an asset class that has increased the most and then reinvesting those proceeds into one of the lesser represented areas could get you back on track. Another approach is to add new money to the lagging area until the mix returns to the intended allocation. 

There’s no official timetable for rebalancing. Suggestions typically are to review allocations annually when assessing your financial plan. It may seem counterintuitive to sell strong performers when they are doing well. There are two old Wall Street adages that come to mind in response to this thought; “Buy low and sell high,” and “a portfolio is like a bar of soap, the more you touch it, the smaller it gets.”

Don’t forget that there are transaction costs and potential tax ramifications to consider when rebalancing. You could realize a taxable gain and owe taxes on your income tax return but there could be opportunities to offset gains with losses. Always consult your trusted team of tax and financial professionals for advice in these areas. It’s rarely the best course of action to have the tax tail wag the dog and make decisions based on taxes rather than remaining focused on your personalized investment strategy. Stay focused and plan accordingly.