What rebalancing a portfolio means and why it is so important (Part1)

Why an active rebalancing policy is essential to achieve and retain healthy long-term returns for clients

As an adviser, it can be hard to hold your nerve when making investment recommendations on behalf of clients. Share price gyrations, sudden market drops and fear of missing out can unsettle the steeliest investor. Such tribulations can undermine the discipline needed for long-term gain and to retain the returns clients need to enable them to meet their goals in life.

Of course, diversification is key. By ensuring that clients have a portfolio consisting of a range of different asset classes and sectors, you can increase the odds that at least one of them will be working hard when the others aren’t. But maintaining the necessary diversity of assets is not something that can be left to chance. Research suggests that keeping the right balance between the different assets over time is an important factor often overlooked when it comes to investment management.

Why is balance so important?

Risk is as important as return or, as billionaire investor Warren Buffett put it, “Rule number 1: never lose money. Rule number 2: never forget rule number 1.” Getting the right balance between risk and reward is not easy. Attaining good “risk-adjusted” returns means maintaining the right proportion of those assets that provide growth, balanced against the right proportion that will provide security. Asset allocation is the biggest influence on a portfolio’s risk and return.

What happens when there is no rebalancing?

An essential part of maintaining a diversified portfolio is to carry out regular rebalancing – ie the regular adjustment of a portfolio so that it keeps returning to the original asset allocation. Say equities make up 75% of a portfolio but then have a good run while other assets languish. That equities portion may end up making up 80% of the portfolio. By rebalancing, you sell until the equities are back to a 75% portion.

You end up selling assets that have performed well and buying ones that haven’t – a prudent move in itself – which helps guard against portfolio drift.

One well known Company recently carried out an exercise to find out how rebalancing, and not rebalancing, would have affected outcomes – the returns achieved versus the risks taken. They used one of the simplest of diversified portfolios split 60% in shares – to provide the growth – and 40% in bonds – to provide the security. While an investment portfolio might start with this division, stockmarket movements mean that it will almost certainly move away from the original “60/40” allocation. They looked at how it would have fared in two 10-year periods,1990-2000 and 2000-2010, with no intervention. They found that a 60/40 portfolio in 1990 would have ended up divided 75/25 by 2000. On the other hand, a 60/40 allocation in 2000 would have become 45% equities and 55% bonds by the end of the decade. In both cases, the better-performing asset class came to dominate the portfolio. That may have worked well in terms of returns, but it would have shifted the risks drastically compared to the original asset allocation.

In our next blog we will consider why an unbalanced portfolio is more risky and how it works.