If you’ve ever tried your hand at using a stand up paddleboard—or SUP—you know how important balance can be. One small shift of your weight in the wrong direction and you’re paddling in the water instead of on it. You also know how tiring it can be to regain your balance over and over again to adjust to even the smallest swell. (It’s no wonder paddleboarding is so good for your core!)
As your portfolio managers, our team at Leisure Capital is well versed in the process of rebalancing. Since our earliest beginnings, we have been dedicated to finding the delicate balance between asset growth and asset protection, and carefully rebalancing our portfolios is vital to achieving that goal. For many investors, however, the process of rebalancing remains shrouded in mystery. What is it exactly, and how does it help you achieve your long-term investment objectives? It’s time to demystify the process of rebalancing once and for all.
Rebalancing: the basics
At the most basic level, rebalancing is a way to manage your investment risk by maintaining an appropriate ‘weight’ of each asset class according to your investment strategy. That equation is based on two primary factors: diversification, which ensures your investments are spread across multiple types of investments; and asset allocation, which is dictated by your personal risk tolerance. To maintain that balance, assets are bought or sold to return your portfolio to the correct weights when it tilts off balance.
The first time your portfolio is implemented, it is created in perfect alignment with your investment strategy. It has the perfect balance. But nothing in life is stagnant—least of all the markets—and change is what causes a portfolio to tilt. Rebalancing is necessary to respond to changes in the market and in your personal circumstances. For example, if a particular asset class increases drastically in value, we may need to sell some of this asset to maintain the right diversification and asset allocation. This recalibration puts your portfolio back in balance.
Because younger investors have a longer investment timeline, they generally have a higher risk tolerance than older investors. For this reason, it is very common to realign the weightings in your portfolio as you age, gradually shifting from higher-risk to lower-risk assets. That’s especially important if you rely on portfolio income in retirement. But age isn’t the only reason rebalancing may be necessary.
For example, a decline in the value of a risk asset (such as equities, commodities, high-yield bonds, real estate, and currencies) causes it to decrease in value and become a smaller percentage of your portfolio. So if your strategy calls for a weight of 60% equities and equities drop in value, they may suddenly account for only 50%. In this case, we may purchase additional equities—at a newer, cheaper price—to rebalance the percentage to the original target of 60%. Conversely, when risk assets appreciate, we may choose to sell a portion of these assets to reduce the risk of overexposure to the asset class while also taking advantage of any continuing trends. It’s all about establishing and regularly reestablishing the right balance.
From a risk perspective, the value of rebalancing can’t be underestimated. The following chart illustrates the real difference in risk and return between a rebalanced portfolio and a portfolio that was not rebalanced over 50 years, 40 years, and 30 years:
As you can see in this example, the rebalanced portfolio presents lower absolute risk and return over each period. Though the average returns on the rebalanced portfolio were slightly lower, it averaged 93.4% of the return compared to the non-rebalanced portfolio—while reducing risk by more than 25%. For many investors, this is a welcome tradeoff that helps them find that important balance between asset growth and asset protection.
How often should a portfolio be rebalanced?
Imagine you’re paddleboarding at Balboa Island. It’s early in the morning, so the water is calm, and there isn’t much boat traffic to stir things up. In those conditions, it’s quite easy to paddle without losing your balance. Take your board out in the late afternoon, however, and you’re in for a completely different adventure. The wind has picked up, boats are everywhere, and the tourists are out in droves. Now the water is turbulent and staying up on that little plank of fiberglass is much more challenging!
Investing in the market is similar. There are times when the market behaves rationally and predictably—and times when it doesn’t. For that reason, there is no absolute rule about how often a portfolio should be rebalanced. For most portfolios in calm market conditions, rebalancing may only necessary two or three times a year. For retirement accounts with no tax liability for creating gains, the need to rebalance may be even less frequent. For non-retirement accounts in more volatile conditions, rebalancing may need to happen more frequently.
When rebalancing is necessary, our approach is to focus on the higher-risk portions of the portfolio to create an optimal balance between risk (we never take on more than we can tolerate) and exposure (to be sure we can achieve growth where it is available). This is how we constantly work toward that balance between protection and growth.
A note about taxes
Rebalancing, by its nature, has the potential for creating tax gains, especially in trust accounts and other non-retirement accounts. This can be true even when we take every possible step to minimize tax liability in those types of accounts. But this is not a reason to avoid rebalancing. Again, deciding when and how to rebalance is all about finding the right balance. While rebalancing can result in tax consequences, the negative impact on the portfolio may be far greater if the account is not rebalanced as it should be and the market declines, creating a significant loss in principle. At Leisure Capital, we always keep tax implications in top of mind—including when rebalancing—but we are mindful not to avoid taxes at all costs, especially when the true cost to the portfolio may be higher than the taxes paid.
Rebalancing is an important process. Without it, you may find that five or ten years down the road your asset allocation is vastly different than when you began, putting the strength of your portfolio at risk. At Leisure Capital, we strive to help every client achieve growth, but our goal is to never take on too much risk. To protect your portfolio and help you reach your long-term financial goals, balance is key—and rebalancing is the key to success.