This article answers a common question from investors.
Q: I have been told that I need to periodically rebalance my investment portfolio. Please explain this and indicate how frequently I should carry it out.
A: When you set up your portfolio you will (hopefully) have gone through an exercise to determine the most appropriate mixture of asset classes corresponding your risk profile and investment term. This will have resulted in a split between growth investments (typically company shares in the UK and overseas) and fixed interest investments.
Over time the asset classes into which you divided your portfolio will have achieved different levels of return. They probably no longer conform to the split which you established at outset.
To correct this it is necessary to re-set the asset allocations back to their original settings – a process known as rebalancing.
Two main academic theories affect rebalancing. ‘Mean reversion’ refers to the concept whereby assets generally return to their long term mean average to you and me) value. The implication of this is that assets which have reduced below their long term trend value should eventually return to it. This phenomenon has been seen to operate over a roughly three yearly cycle.
The other factor is ‘Momentum’. This describes the observed phenomenon whereby asset values tend to continue moving in the same direction for a period. It has often been compared to the movement of a wave which continues to sweep up the beach once it has broken before retreating. Momentum has been seen to occur over shorter periods than ‘Return to mean’, typically up to a year.
‘Mean reversion’ is a factor which favours more frequent rebalancing since it supports the disposal of assets which have performed well in favour others which have under-performed.
‘Momentum’ supports leaving the portfolio as it is, at least for a while, because it explains how assets which have been performing well can be expected to continue to do so for a period.
Two additional factors influence the frequency of rebalancing; transaction costs and taxation. The latter can be disregarded if the investment is held in tax exempt shelters such as pensions and ISAs. The former is relevant because dealing costs can erode the benefits derived from rebalancing and are a major factor in favour of less frequent rebalancing.
Rebalancing can be carried out whenever the asset allocations stray beyond a certain percentage of target levels, or at set intervals (e.g. quarterly, half yearly or yearly), or a combination of both of the above. The optimum method depends on the nature of the portfolio. In order to make best use of the two factors described above there is also the question of exactly how to perform the rebalancing exercise i.e. whether to exactly restore all asset allocations to their original levels or for the worst performing asset classes to be restored to a lower level and the best performing assets to a higher level.
There is much research into the benefits of rebalancing and some suggest that it can actually increase long term returns without increasing the risk of the portfolio. However, other research indicates that care needs to be taken with the extent to which this is relied on if the data is based on too short a period.
At an intuitive level, it is evident that the restoration of the portfolio to the original levels based on your risk profile will ensure that you are not subjected to excessive levels of anxiety about your portfolio since its risk exposure will be managed.
Whilst academics will continue to argue about the benefits of rebalancing and the optimum method of applying it, most are in agreement that it is beneficial, especially for higher growth oriented portfolios. Due to the impact of dealing costs it probably does not need to be carried out more than annually.
Some research suggests that for higher growth orientated portfolios rebalancing when the assets fluctuate by 20% or more in value can deliver a greater degree of performance enhancement.
Key Considerations:
On balance the most pragmatic approach would be to review your portfolio at least annually and to consider rebalancing more frequently where asset classes change in value by more than 20%.
Action Point
Get hold of all your investments and look at the overall asset allocation of your whole portfolio. Then either contact your adviser or search for an online tool to analyse how much exposure you have to growth assets (shares/property). Once you have all this information you can make intelligent decisions and adjust your asset allocation where necessary.
NB: Our thanks to Financial Planner Chris Wicks for providing this week’s article.
