Individual Investors: Advice For Year End Rebalancing

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As the end to 2013 quickly approaches, you’re probably starting to think about how to rebalance your portfolio. Most individual investors don’t really think about asset allocation when crafting their basket of investible securities.  If you did structure your portfolio with certain objectives in mind, there is no doubt that your allocation now is different from what it was at the beginning of the year.  Market forces, for better or for worse, change the relative weight of assets in a given portfolio.  If equities perform well, you might find yourself too heavily weighted in this particular asset class, with insufficient downside protection or cash flow yield.  If stock prices go down, you might worry that you are no longer able to reach your financial goals in the timeframe you initially set.

Assuming you created a portfolio with a strategic objective and allocation, have you developed a strategy for dealing with these changes?  You’ll probably want to take a look at your individual investments to ascertain whether they still fit your investment philosophy, but you’ll also want to think about your asset allocation and how any periodic adjustment of it would help you achieve your investing objectives.

Obviously, simply making no changes would be easiest.  On an emotional level, if you’re happy with your portfolio’s current return profile it may be difficult to make any significant changes.  We are all guilty of subscribing to a “if it ain’t broken, don’t fix it” mentality.  Of course, allowing the status quo to persist may affect how well your investments will continue to match your goals, especially during unexpected (and eventual) turns in the market.  At a minimum, you should periodically review the rational for your investment choices to ensure that they still hold.

Constant Weighting
It might feel counterintuitive, but selling the winners and buying the losers (or other investments in underrepresentitive sectors) can bring your asset allocation back to the original percentages you had initially set.  This ‘constant weighting’ of relative investment types ensures that your portfolio grows at a proportional rate, factoring in all asset classes represented in the portfolio.

Let’s consider a hypothetical example. If your equity allocation in a portfolio that originally represented 50% is now at 70%, rebalancing would involve selling some of the stock and using the proceeds to buy back enough of the other asset classes to bring the portfolio back to 50% in equities.   Similarly, if stocks now represent less of your portfolio than they should; to rebalance, you would invest in stocks until they once again reach an appropriate percentage of your portfolio.  Maintaining relative percentages not only reminds you to take profits when a given asset class is doing well, but it also keeps your portfolio in line with your original risk tolerance.

When should rebalancing take place? One common practice is to rebalance a portfolio whenever a particular investment represents significantly more than it’s intended share of the portfolio (we call this a ‘tolerance band’); say, 5% to 10% of the total portfolio.  One could also set a regular date for rebalancing,  say, tax time or year-end.

Forecast Weighting
You could also adjust the mix of investments to focus on companies and sectors that are expected to do well in the future.  This is obviously a more speculative approach, and one that more active individual investors attempt to employ.  I would not recommend this strategy as a sustainable practice for long-term portfolio growth.

A Hybrid Approach
You could also combine the above two strategies by maintaining a constantly weighted asset allocation with one portion of the portfolio. With another portion of the portfolio, you could try to take advantage of short-term opportunities, or test specific sectors that you believe might benefit from a more active investing approach.  By monitoring your portfolio, you can always return to your original allocation.

A Bottom Line Approach
Another plausible solution is to set a “bottom line” for your portfolio; that is, a minimum dollar amount that the portfolio cannot dip below.  If you wish to be active with your investments, you can do so–as long as your overall portfolio stays above your bottom line.  I do not advocate active management in this fashion, but with this strategy you could theoretically move the portfolio to very conservative allocation (more conservative securities or cash) to protect that baseline amount.   Keep in mind that many speculative investments are illiquid, which presents additional and significant problems when trying to exit losing positions.

Key Rules for Rebalancing:

  1. Be aware of market conditions and how your investments might react to them.  Certain investments counteract the risk of others.  Plan your portfolio with ‘risk’ in mind and rebalance with the same objective.
  2. Be disciplined with your strategy and stick to your rebalancing plan.  Do not deviate from it.
  3. Stay true to your investment philosophy and check to ensure that the nature of what you’ve invested in hasn’t changed.  You may own a particular mutual fund that overexposes you to a particular sector or geography.  This kind of “style drift” happens, but as an investor you must remain aware of what you own and why you own it.

Don’t forget about taxes and transaction costs
Frequent rebalancing can trigger tax consequences and expensive transaction costs. Check on whether you’ve held particular securities for over a year. If not, you may want to consider whether the benefits of selling immediately will outweigh the higher tax rate you’ll pay on short-term gains.  This doesn’t affect qualified accounts such as 401(k)s or IRAs, which are tax deferred.

I hope this information is helpful to you as you work to rebalance your investments for the year ahead.  Please do not hesitate to contact me should have any questions about this article or if you are interested in discussing specifics about your portfolio.

Best regards,
Jason M. Gilbert, CPA/PFS, CFF
T: 516-665-7800
E: [email protected]


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