FinSyn Insights

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A Surgical Approach to Rebalancing

As we have all experienced, time and repetition can cause us to take for granted things that others recognize as being extraordinary. During the past week, two new clients mentioned how impressed they were with the rebalancing strategy we employ, and I was reminded that we often take for granted the significance that this rebalancing strategy has for our clients’ portfolios.

Before getting into how we implement our rebalancing strategy, it might be helpful to start with an explanation of what rebalancing is and why it’s important.  Rebalancing is simply the process of buying and trimming investments in the portfolio to bring them back to their target weightings. As a simple example, assume you have a portfolio with 50% in stocks and 50% in bonds. When stocks do really well (as they did in 2013) and bonds lag (as they did in 2013), that original 50/50 weighting is thrown out of balance. Now you have a portfolio that might be something like 65% stocks/35% bonds. It’s important to address this “out-of-balance” state for two reasons.

First, we now have an unintended overweight to one category (stocks in this example). We know that every investment category runs in cycles. While we don’t know exactly where we’re at in the cycle in real time, we do know that any category that has experienced a big run-up is likely to cool off at some point. In this example, our 50% allocation to stock has been allowed to run up to 65% which puts the portfolio at greater risk should a selloff occur. Thus, rebalancing is a way to reduce risk in the portfolio by taking profits (“selling high”) from categories which have done well.

The second reason to address the portfolio’s out-of-balance state is that we now have an unintended underweight to another category (bonds in this example). Based on our thesis that all asset classes run in cycles, we now have an opportunity to add money to a category which has underperformed. This is a way to average down our cost basis and provide greater upside potential when that category returns to favor. Thus, rebalancing is also a way to increase returns in the portfolio by adding to categories that are temporarily out of favor (“buying low”).

Now most financial advisors will agree that rebalancing a portfolio makes sense, but the methods for implementing a rebalancing program generally fall into two very different camps. The first method is the calendar-year rebalance. Put simply, the entire portfolio is rebalanced back to its target weightings (50/50 in our example) on the same day, usually the first trading day of each year. This is the easiest approach to rebalancing, but it has one very significant flaw: the portfolio may not actually need to be rebalanced on the scheduled day.

Consider the year 2011 as an example. Have a look at how much volatility the market (as measured by the S&P 500) experienced:

From 1/3/11 – 7/7/11, the S&P 500 rose by about 7%

From 7/8/11 – 10/3/11, the S&P 500 fell by about 19%

From 10/4/11 – 1/3/2012, the S&P 500 rose by about 14%

Knowing how wide the fluctuations were in 2011, it may be of interest to know that the S&P 500 started the first trading day of the year at about 1,272 on Jan. 3, 2011 and it closed on Jan. 3, 2012 at about 1,277, a change of only 0.39%. Now if you had employed a calendar year rebalance at the beginning of each calendar year, you would have missed the opportunities presented by the intra-year volatility. Moreover, you would have incurred trading costs (transaction fees) for rebalancing the portfolio, even though it didn’t need to be rebalanced.

That leads us to the second method, which we employ. It involves rebalancing on a more surgical, as-needed basis. This method is much more difficult to implement because it requires constant monitoring to be effective. It is, therefore, not nearly as common as the calendar year rebalancing method. Each asset class in the portfolio is given a range on both the upside and the downside within which to operate. In our basic 50/50 example, it might look something like this: as long as no category exceeds a maximum 60% weight or drops below a minimum 40% weight, we leave the account alone. But as soon as one of those levels is breached, a rebalance is triggered.

Now apply that same rule to a portfolio with 16 to 20 investments, a typical Financial Synergies account. Every category is given a range, or “tolerance band,” within which to operate. For more volatile asset classes, like small cap stocks or real estate, the range is wider. For more conservative investments, like bonds, the range is narrower. Every week, our Portfolio Manager, Mike Minter, subjects each client’s portfolio to a test to determine whether or not any of the investments are out of bounds, either on the upside or the downside. If so, a rebalance is triggered, but only those asset classes which are out of tolerance are traded. This means that the rebalance is much more “surgical” than a complete reshuffling of the portfolio. In many cases only two or three funds are bought or sold in a rebalance, which helps to minimize trading costs.

By utilizing sophisticated software, we are able to monitor each and every weighting across hundreds of portfolios, pouncing on rebalancing opportunities as they arise. While we take it as a matter of course, our perceptive new clients were quick to recognize that this as-needed, surgical approach reduces transaction fees, mitigates risk and boosts returns.

Bryan Zschiesche

Bryan is a CERTIFIED FINANCIAL PLANNER™ and Senior Financial Advisor. He uses his expertise to develop investment strategies to protect and grow clients’ retirement savings. Bryan is a proponent of Elegant Simplicity, the idea that we can work through complex issues surrounding a financial problem and arrive at a sophisticated but simple solution.   Read Bryan’s Profile HereRead More Articles by Bryan

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