Strategies for portfolio rebalancing

Make rebalancing your portfolio a resolution for 2016. Consider your circumstances, set targets . . . and stick to them.

Rebalancing your portfolio is critical to successful investing. We advise you to assess and set your asset allocation and then rebalance throughout the year.

Asset allocation is the way you spread your money across different types of investments (such as stocks, bonds and Treasury bills). Your asset allocation greatly affects your returns. In the short run, stocks give better—but more volatile—returns than bonds and T-bills.

Assess your circumstances before setting your desired asset allocation. First, assess how much risk you can accept. Second, consider how long you plan to invest for—your ‘investment horizon’. Then, depending on your situation, set long-term targets for how much money you’ll keep in each asset class.

Suit your own circumstances

Young and middle-aged investors with safe jobs, for instance, can afford to take more risk, particularly if they plan to buy and hold stocks for more than five years. Those who lack job security or are self-employed should allocate less money to stocks and more to cash, particularly within a Tax-Free Savings Account (TFSA). After all, they may need that cash.

Retirees should use fixed-income investments to cover their expected cash needs for at least each of the next five years. Each year, as the one-year investment matures, retirees should buy a new five-year investment to replace the one that will now mature in four years. Then retirees can invest long-term money in high-quality, dividend-paying stocks.

After you set targets for your asset allocation, review your holdings periodically—at least once every six months. The chances are that ‘portfolio drift’ will have unbalanced your portfolio. To restore your desired asset allocation, you should rebalance.

Say that you want half of your money in stocks and the other half in bonds. In 2015, stocks as measured by the S&P/TSX Composite Index fell by 11.1 per cent. Bonds, as measured by the FTSE TMX Canada Universe Bond Index rose by 3.5 per cent. As a result, you should rebalance. That is, you should put new money into stocks until they account for half of your portfolio. You could also allow bonds to mature and shift the proceeds into stocks until your bonds again represent half of your portfolio.

In short, given your circumstances, set suitable long-term targets for what percentage of your money to keep in each asset class. Then stick to your targets by rebalancing.

Rebalance and profit as a contrarian

Contrarian investors look at what the crowd is doing and do the opposite, provided that it makes sense. They sell ‘market darlings’ at high prices and use the cash to buy ‘fallen angels’ at low prices. By selling high what they previously bought low, contrarians usually make more money than others.

The trouble is, going against the conventional wisdom and acting as a contrarian investor always feels wrong and requires plenty of courage. Despite this pitfall, there’s a way you can automatically follow a contrarian approach. You start by setting targets for your asset allocation. Then, as what’s known as ‘portfolio drift’ unbalances your portfolio, you rebalance, as discussed above.

Rebalancing leads you to sell part of the asset classes that did best (currently bonds) and reinvest the cash in asset classes that lagged (recently stocks). The idea is to do this until you re-establish your desired asset allocation.

More importantly, selling the relatively costly asset classes and moving the proceeds as well as new money to the relatively cheaper asset classes means you will have taken profits and then bought the cheaper asset classes at better prices.

‘Portfolio drift’ can cost you money

As Mr. David Swenson, chief investment officer of Yale University’s investment office puts it, “The portfolio should be rebalanced regularly to long-term targets. Rebalancing imposes a discipline that results in buying low, after a decline in an asset’s relative price, and selling high, after a rise in relative price.” You can go even further.

Given the fall in the loonie and the rise in the U.S. dollar, consider rebalancing towards Canada. Some of this country’s solid companies are now bargains.

You can rebalance your portfolio among the five main economic sectors: finance, utilities, consumer products and services, manufacturing and resources. You can also rebalance within a sector. Within the financial sector, for instance, you might buy one bank, one insurance company and a mutual fund firm.

In fact, you can rebalance away from even just one stock. In September, 2000, we wrote, “It’s quite possible that Nortel Networks has come to account for more and more of your portfolio. In fact, it may weigh too heavily on your portfolio—just as it does in the market indices. In this case you might consider taking some profits from this manufacturing company.” Being a contrarian—selling Nortel while most were buying—paid off handsomely.

That is, rebalancing can let you profit from contrarian investing, ensure your asset allocation suits you, and eliminate portfolio drift. The trouble is, rebalancing is costly.

Rebalancing is wise, but it’s also costly

As we emphasized above, rebalancing is a smart strategy. It lets you side-step the trap of portfolio drift (where changes in market prices change your asset allocation). Instead, rebalancing keeps your portfolio balanced and at your desired asset allocation targets. This should help you sleep at night. Rebalancing also enables you to profit from contrarian investing. But unfortunately, rebalancing is costly.

One cost of rebalancing is that you incur brokerage fees, of course. You pay one fee to sell costly investments and another to buy cheap investments.

Less obvious, you enrich “market makers” through the bid-ask spread. That is, when you sell, you’ll usually receive the lower bid price. When you reinvest, you’ll likely pay the higher ask price. You could hold out for the ask price when you sell and the bid price when you buy. But this is apt to cost you even more in lost investment opportunities.

A third cost with rebalancing is the income tax you pay on realized (or taken) capital gains. Since you’re selling investments that have mostly gone up in price you’ll face taxable capital gains most of the time. The exceptions are when you take profits in tax-deferred accounts such as your Registered Retirement Savings Plan, Registered Retirement Income Fund or Tax-Free Savings Account.

A fourth cost is that you lose the benefit of unrealized gains. Mr. Warren Koontz Jr., vice-president and treasurer of U.S.-based The Jeffrey Company has written: “The value of unrealized gains is often overlooked. Unrealized gains are the portion of a portfolio’s principal growth that has not been realized and diminished by taxes. The longer the gains remain unrealized, the more valuable they are, because deferred taxes on unrealized capital gains compound for the investor instead of Uncle Sam.” The same holds true in Canada.

Outside of tax-deferred accounts, keeping unrealized gains means using a buy-and-hold strategy. Critics say “frozen” buy-and-hold portfolios earn lower returns. But the evidence shows that buy-and-hold portfolios usually do better.

Professors Josef Lakonishok, Andrei Schleifer and Robert Vishny examined whether money managers raise the returns of actively-managed funds. They found that on average, buy-and-hold portfolios beat actively-managed ones by 0.78 per cent a year—excluding taxes, management fees and cash holdings (which hurt the returns of actively-managed funds). Professors Lakonishok, Schleifer and Vishny concluded that the trading of active managers hurt the performance of their funds. That’s why unmanaged exchange-traded funds have become so popular.

Still, you can reduce the costs of rebalancing by tying it to your ordinary investing.


The MoneyLetter, MPL Communications Inc.
133 Richmond St. W., Toronto, On, M5H 3M8, 1-800-804-8846

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