The asset allocation strategy that you adopt plays an important role in determining your success as an investor. The first step, of course, is to understand your risk tolerance. Are you the type who panics when the stock that you have purchased in a certain company falls by 10% in value? Or do you see this as an opportunity to buy more of the stock?
When you understand your risk profile, you can arrive at an asset allocation strategy that meets your requirements. If you are an aggressive investor, you may decide to invest 80% of your capital in stocks and the remaining in bonds.
An individual who does not want to take on so much risk could opt for a 60/40 balance between stocks and bonds.
However, regardless of the asset allocation that you decide upon, the relative proportion of your investments in stocks and bonds will change over time. An increase in stock market valuations will lead to your portfolio becoming weighted towards stocks.
Conversely, a fall in the stock market will result in your bond holdings exceeding your pre-decided percentage. When this happens, it may be time to rebalance your portfolio.
Remember that rebalancing is about managing risks. If your stock holdings grow as a percentage of your total portfolio, it leads to an increase in the level of risk that you carry. An excess of bonds will lower the risk that your portfolio is exposed to but will limit growth.
Rebalancing has another important benefit. It forces you to sell high and buy low. But before you start this rebalancing exercise, here are a few points that you may want to consider:
# 1: It isn’t a yearly exercise
Rebalancing your portfolio in the same month every year is not really the best approach. While it’s better than not carrying out a review at all, there is a better way to address this issue.
You should keep a close tab on the composition of your holdings. If your original stock-to-bond ratio is 60/40 and rising share valuations take it to 65/35, it may be time to rebalance even if only six months have elapsed since the last exercise.
Rebalancing when the stock market falls can be especially beneficial. A study carried out by US fund management group Vanguard found that investors who followed this practice in a bear market gained a distinct advantage. They bought equities at depressed prices, a step that resulted in large capital gains.
What if you don’t rebalance your portfolio at all? The Vanguard study, which examined US stock market data from 1926 to 2010, reported that a 60/40 portfolio would have been transformed into one that held 97% in equities. While this may suit a person with a high level of risk tolerance, it is definitely not the type of portfolio that a conservative investor would like to hold.
# 2: Deciding what to sell
If your stocks have outperformed your bonds, you will have to dispose of some stocks. The proceeds will need to be re-invested in fixed income securities. But how will you decide which stocks to sell?
This can be a big dilemma for investors. The very fact that you need to sell stocks indicates that your equity holdings have performed well. You may think that your stocks still have the potential to increase in value. You don’t want to be in a situation where you sell the shares of a particular company only to see the price shoot up subsequently.
There is practically no way to ensure that this does not happen to you. But there is a certain method that you can adopt as a precaution. Review your equity holdings and see if you would be willing to purchase the shares that you own at their current prices. Every stock that meets this condition should be retained. You can consider selling the others.
# 3: Don’t overdo it
Rebalancing is not really required if your stock-to-bond ratio changes by 1% or 2%. A good rule of thumb to follow is to carry out the rebalancing exercise when the shift is about 5%. Making the change at 10% is also quite acceptable.
Don’t be in a hurry. A short-term price movement may prompt you to rebalance your portfolio. But if you change the mix of your holdings too quickly, you may need to rebalance once again when the market reverts to its prior level. Additionally, selling your stocks in response to a rise in prices may lead to the loss of future gains.
#4: A measured approach is preferable
It’s important to differentiate between short-term volatility in the stock market and a more permanent shift in the market’s direction. But it can often be difficult to do this.
If you are not sure if prices are rising because of the start of a new bull market, should
you rebalance your portfolio? A good approach to this type of situation is to rebalance in phases. You could consider carrying out the exercise over two or three months. In this time, it is likely that you will get greater clarity about the market’s direction.
#5: Has your risk profile changed?
Conventional wisdom says that as you age, you should move more of your investments to safer fixed income securities. While this rule does not apply to everyone, it is a good idea to review your risk tolerance periodically. If you have to pay your children’s college fees or if you have to support your parents, you may not be willing to expose your investments to great volatility.
The next time you carry out a rebalancing exercise, see if your existing stock-to-bond ratio meets your requirements. If it doesn’t, you should reapportion your investments accordingly.
THE BOTTOM LINE
It’s important to remember that rebalancing carries a cost. Every time you buy or sell a financial security, you will have to incur trading expenses. If you rebalance too often, these can add up to a significant amount and reduce the rate of return on your portfolio.
The best option is to rebalance by buying new securities with cash. This will save on costs and help to build your portfolio. However, if you cannot do that, then you will have to adopt the traditional route of selling some securities and reinvesting the proceeds.
The Privé Technologies Team