A considerable amount of questioning, organizing and thinking goes into the process of determining how an individual should invest their savings. Factors like age, expected cash flows, family goals, risk tolerance and taxes are all taken into account when constructing an investment strategy. The initial purchase and weighting of securities and assets is the culmination of much planning and thought.
Once these purchases are made though, market prices begin to change. Certain assets outperform, and what was initially a 10 percent weight to an investment may become a 15 percent weight. Other investments underperform and may try an investor’s patience. After some time, the prices and weights in the portfolio may look much different than they did at inception.
At this point, we face a decision: What, if anything, should be done with the investments and their weights? Exencial views these price and weight changes as an opportunity to improve risk management and/or expected return through rebalancing1, the process of realigning the weightings of a portfolio. Many investors are familiar with this concept but are often unaware of its benefits.
In practice, rebalancing is similar to what prominent investor Benjamin Graham described as interacting with “Mr. Market.2” At certain times, Mr. Market is euphoric and will offer to buy certain assets at high prices or valuations. Investors should consider selling at least a piece of high-priced assets at these times. Other times, Mr. Market is depressed and will offer to sell certain assets at lower prices or valuations. This is when an investor should consider buying some of these assets.
A primary benefit of rebalancing is improved risk management. To safeguard your portfolio, it’s critical to ensure that a few assets don’t grow so large as to dominate a strategy or that a few components’ weights wither to a point that they no longer serve their intended purpose. Rebalancing these assets validates and maintains the original investment strategy.
Another advantage of rebalancing is the potential for higher expected returns. Inevitably, some assets will perform better than others over a period of time, and the weights to the investments will begin to drift from their initial targets. When the investments’ weights drift too far from their targets, it may make sense to sell overweighted assets and buy underweighted assets to try to return weightings closer to their initial target.
The above sample portfolio is weighted to the following indexes: 6 percent DJ U.S. Select REIT, 15 percent S&P 500, 15 percent Russell 1000 Value, 15 percent Russell 1000 Growth, 20 percent Russell 2000 Value and 29 percent MSCI Europe USD GD. Rebalances are done every 12 months back to target.
We can see that rebalancing significantly improved this portfolio’s returns over the long term. Below are several highlights:
Certainly not every rebalance trade provides a “bonus,” especially in the short term. However, historically, rebalancing has provided investors with higher returns over longer periods of time. A recent study conducted by Vanguard3 estimates returns can be improved 0.35 percent per year through rebalancing. As mentioned, Exencial has also analyzed historical rebalancing and has discovered a similar benefit.
There are trading costs and potential taxes to be considered though, which is why we attempt to rebalance our clients’ assets in an efficient and cost-conscious manner. To accomplish this, we follow the below guidelines when rebalancing:
Rebalancing helps manage risks and can put investors in a position to capture slightly higher expected returns. Exencial seeks to capitalize on these benefits while also taking judicious measures to avoid unnecessary trading costs and tax burdens. For additional information or if you have questions, please contact your advisor.
Sources:
1. Investopedia – Rebalancing
2. Investopedia – Mr. Market
3. Vanguard – Putting a value on your value: Quantifying Vanguard Advisor’s Alpha®
PAST PERFORMANCE IS NOT AN INDICATION OF FUTURE RETURNS. Information and opinions provided herein reflect the views of the author as of the publication date of this article. Such views and opinions are subject to change at any point and without notice. Some of the information provided herein was obtained from third-party sources believed to be reliable but such information is not guaranteed to be accurate. In addition, the links provided within are for convenience only and the provision of the links does not imply any sponsorship, endorsement, or approval of any of the content. We do not guarantee the content or its accuracy and completeness. The content is being provided for informational purposes only, and nothing within is, or is intended to constitute, investment, tax, or legal advice or a recommendation to buy or sell any types of securities or investments. The author has not taken into account the investment objectives, financial situation, or particular needs of any individual investor. Any forward-looking statements or forecasts are based on assumptions only, and actual results are expected to vary from any such statements or forecasts. No reliance should be placed on any such statements or forecasts when making any investment decision. Any assumptions and projections displayed are estimates, hypothetical in nature, and meant to serve solely as a guideline. No investment decision should be made based solely on any information provided herein and the author is not responsible for the consequences of any decisions or actions taken as a result of information provided in this book. There is a risk of loss from an investment in securities, including the risk of total loss of principal, which an investor will need to be prepared to bear. Different types of investments involve varying degrees of risk, and there can be no assurance that any specific investment will be profitable or suitable for a particular investor’s financial situation or risk tolerance. Exencial Wealth Advisors, LLC (“EWA”) is an investment adviser registered with the Securities & Exchange Commission (SEC). However, such registration does not imply a certain level of skill or training and no inference to the contrary should be made. EWA may only transact business in those states in which it is registered, notice filed, or qualifies for an exemption or exclusion from registration or notice filing requirements. Complete information about our services and fees is contained in our Form ADV Part 2A (Disclosure Brochure), a copy of which can be obtained at www.adviserinfo.sec.gov or by calling us at 888-478-1971