Is It Time to Rebalance Your Portfolio?

Portfolio rebalancing means buying and selling securities with the objective of moving the portfolio back to its target asset allocation. Rebalancing has two primary benefits for investors. First, rebalancing is demonstrated to enhance portfolio returns by as much as 0.5% per year. This is due to a phenomenon called mean reversion. Although returns on a particular asset class may be significantly over or under their expected return in the short term, they tend to revert to their long-term averages over time, so investors can benefit by selling (or buying) the asset allocation when its value is above (or below) its long-term average. The second benefit of rebalancing is risk reduction. When we help clients develop an Investment Policy, we are agreeing to implement a portfolio with a certain risk profile. As the actual allocation changes due to market movements, the portfolio becomes more or less risky. Rebalancing restores the desired level of risk to the portfolio. Because stock markets typically rise over long periods, rebalancers become net sellers of stocks, meaning that the long-term volatility of their portfolios is significantly less than that of portfolios which are never rebalanced.

Despite these benefits, studies have shown that most individual investors do not routinely rebalance their portfolios. Why is this? The contrarian, out-of-the-mainstream behavior required when rebalancing is quite uncomfortable for many investors. David Swenson, the former Chief Investment Officer at Yale University, wrote in his book Unconventional Success:

• Contrarian behavior lies at the heart of most successful investment strategies. Unfortunately for investors, human nature craves the positive reinforcement that comes from running with the crowd . . . Contrarian investment behavior requires shunning the loved and embracing the unloved. Most people do the opposite.

• Rebalancing represents supremely rational behavior. Maintaining portfolio targets in the face of market moves dictates sale of strong relative performers and purchase of poor relative performers. Stated differently, disciplined rebalancers sell what's hot and buy what's not. Under normal circumstances, rebalancing asks for modest degrees of fortitude when markets make extreme moves, rebalancing requires substantial amounts of courage. 

Our rebalancing process at Arcadia Private Wealth involves two steps: First, we compare the client's current asset allocation to the target asset allocation specified in their Investment Policy and determine whether rebalancing is necessary. Rather than rebalance on a strict periodic schedule, we allow portfolio allocations to float within bands around the target. For example, if the portfolio allocation to U.S. small cap stocks drops below the lower band, we will need to add U.S. small cap stock funds. If the allocation exceeds the upper band, we need to reduce the asset class. Second, once we decide that rebalancing is necessary, we choose the most cost-effective means of doing so. This is the most difficult step since the benefits of rebalancing can easily be nullified by excessive transaction costs or capital gains taxes. Our rebalancing plan typically consists of a combination of the following actions. In order of preference, we may:

1. Use new deposits to purchase underweighted asset classes. Because this approach results in zero tax liability and relatively low transaction costs, it is our preferred rebalancing method. However, it is seldom realistic or sufficient.
2. Sell securities with unrealized losses in taxable accounts. Such sales result in a two-fold benefit for the client: a freshly rebalanced portfolio and a realized loss for tax purposes. 
3. Sell securities in a tax-deferred account such as an IRA. Tax-deferred accounts are valuable tools for rebalancing since selling can be done without incurring any tax liability.
4. Sell securities with unrealized gains in taxable accounts. Because of the income tax implications, this is our least favorite means of rebalancing. However, after extended bull markets and for clients without large tax-deferred accounts, selling appreciated securities in a taxable account may be necessary. If this method is used, we may mitigate the tax impact by: a) rebalancing towards, but not all the way back to the target asset allocation; b) ensuring that any realized gains are characterized as long-term and therefore receive the 15% federal capital gains rate; and c) utilizing any capital loss carryforwards the client may have to offset the realized gains. 

Disclosure: This article is for informational purposes only and does not constitute personalized tax, legal, or investment advice. Tax rules are subject to change. Please consult a qualified financial advisor and CPA for guidance specific to your situation. Arcadia Private Wealth LLC is a Registered Investment Adviser in the state of California. Advisory services are only offered to clients or prospective clients where we are properly registered or exempt from registration.