At PFW we are passionate about delivering a service that is not purely investment management (a message that I hope, without overdoing it, we have delivered to you so far). That being said, we do recognise how important professional investment management that delivers results is, so we wanted to post today about the power of regular rebalancing.

Rebalancing is a regular event – annually, bi-annually, quarterly, it doesn’t really matter (frequency is less important than consistency). You may have heard about this from your previous or current adviser, or even from us, and not fully understood why it was being recommended. What does “rebalance your portfolio” actually mean? After all, your equities are probably the best performing asset class in your portfolio, so why are we selling out of the best performing asset?

Before I start, if you haven’t had a portfolio rebalance in the last few years then you will almost certainly have a far more volatile (riskier) portfolio than you set out with – you may even have felt this in the December sell off? And yet you are several years closer to retirement, so in principle shouldn’t you have a less risky portfolio?

I’m sure you’ve heard it said of the unsuccessful investor that, following the herd, they buy high and sell low? Well, rebalancing is a disciplined risk-reduction strategy whereby, in essence, you sell the winners (i.e. sell high) and buy the losers (i.e. buy low).

You do the opposite of the unsuccessful investor, but this can feel very unintuitive – uncomfortable even – at the time.

We start by agreeing an asset allocation with our clients at the outset. I’m not going to go into how we arrive at that asset allocation in this blog, because it is individual to each client and involves a plethora of different factors, but by asset allocation I mean, broadly, equity Vs fixed income exposure in your portfolio.

Equity is the engine – it provides the meaningful growth, over time – but the cost of this is volatility. And by volatility I really mean it goes through periods where it falls in value, often violently. Fixed Income is the “buffer” – it usually increases in value, but not meaningfully. When equity is falling, fixed income usually acts as a buffer and protects investors from suffering to the same extent of the market. But the cost of this is that fixed income acts as a drag on performance in the good times.

As an investor you want to find the right balance between buffer and drag. Not so much buffer that you impede your growth more than you need to to be comfortable and not so little buffer that you wake up in cold sweats every time there is some market volatility (one thing we can guarantee there will be).

Left unchecked, because equity grows by more than fixed income and because equity grows way more frequently than it does not, investors can end up with significantly more equity than they originally set out with. And that means that they now have a much more volatile (risky) portfolio than originally intended, meaning they participate in the dips much more than originally intended.

Take a look at the chart below. In the run up to the 2008 Global Financial Crisis (GFC) REITS, commodities and developed market equity were on fire, while fixed income was much more pedestrian. If an investor had started out with 65% in equity, REITS and commodities and the rest in fixed income, by the end of 2008, having not undertaken any rebalancing, they would have been wildly overweight  (i.e. way over 65% exposure) in these asset classes.

2008 arrives with a bang and the top performing assets classes suffer, as top performing asset classes so often do, and boring, pedestrian fixed income is catapulted to the top of the chart.

Had you been practicing annual rebalancing, each year we would have “reset” your portfolio back to 65% in equity etc. Each year, we would be imploring you to reduce your exposure to an outperforming asset class and you may have been left scratching your head trying to understand why.

Come 2008 and suddenly it would be brought home with a bang.  Had we allowed your agreed upon 65% exposure to balloon to, say, 75% or 80% at the expense of your fixed income buffer you would have suffered more than you were meant to. Had we been rebalancing you back to 65%, come 2008, it wouldn’t have been pretty or comfortable, but 35% of your portfolio would have been invested in an asset class that delivered 5.2% – that would have certainly softened the blow.

You see, at its core, rebalancing is the only guaranteed way us mortals can consistently “buy low and sell high”. If we all agree that no one has a crystal ball and trying to time markets is a fool’s game (and to be a client of PFW we really do need to be on the same page here) the only way we can consistently do this is to sell out of investments as they are rising and use the money taken from them to buy into under-performing assets, so when the tables are turned – and they will be turned – 1. you aren’t over exposed to the assets that take the biggest hits; 2. you have a level of exposure that, in theory, you are comfortable with and you can get on with living your life and 3. we’ve bought into the previously under-performing asset class that suddenly comes into its own.

Now, I have looked at this from a equity Vs fixed income perspective, but exactly the same principles are applied to the different equity sectors within your equity portfolio. The folly of the unsuccessful investor is to chase last year’s winners. But last years winners rarely repeat that feat. By taking some of the gain out of the winner and redirecting it to the wider portfolio, we significantly increase the likelihood of redirecting some of it to the coming year’s winner(s).

In the absence of a crystal ball, it’s the best tool we have and whilst it’s incredibly simple it is an oft neglected element of portfolio management.

What we are trying to convey here, in this very simplified account of rebalancing, is the value of a Life-Centered Financial Planner who also understands the economic principles behind professional portfolio management.

Whether we are long in the tooth of this market or not, if you haven’t undergone this standard portfolio management process, we would encourage you to ask the question of where your portfolio stands today Vs the initial investment – you may well be surprised

Plan First Wealth is a registered investment adviser.  Information presented is for educational purposes only and does not intend to make an offer or solicitation for the sale or purchase of any specific securities, investments, or investment strategies.  Investments involve risk and, unless otherwise stated, are not guaranteed.  Be sure to first consult with a qualified financial adviser and/or tax professional before implementing any strategy discussed herein. Past performance is not indicative of future performance.