Rebalance your portfolio, rebalance your emotions

24 April 2019 | Portfolio construction

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Is your portfolio suffering from what is sometimes called portfolio drift?

This occurs when a broadly-diversified portfolio drifts away from its strategic or target asset allocation with movements in investment markets and diverging returns from lower-risk and higher-risk assets.

Your diversified portfolio's strategic asset allocation to different asset classes should be set with the aim of reaching your goals without exceeding your tolerance to risk. (See Goodbye to ad-hoc portfolios, Smart Investing, April 15.)

And then regular rebalancing of your portfolio back to that asset allocation will regain its intended risk-and-return characteristics. The primary benefit of rebalancing is to keep a portfolio's risk profile, not to maximise returns.

In today's low-interest, lower-return investment environment, investors may be more tempted to delay rebalancing their portfolios. This is a trap because a portfolio usually becomes progressively more volatile and riskier without rebalancing.

Repeated research* over more than 30 years, including by Vanguard, has concluded that a diversified portfolio's strategic asset allocation is the main cause of variations in its long-term returns.

A recent Vanguard research paper, Getting back on track: A guide to smart rebalancing**, suggests three straightforward practices for portfolio rebalancing:

  • Rebalance to manage your risks and emotions: A disciplined, easy-to-follow rebalancing strategy helps remove emotions from your investment decisions. And as discussed, rebalancing reduces the likelihood of your portfolio becoming riskier with movements in investment markets.
  • Set rebalancing trigger: Most investors following a rebalancing strategy use either a "time trigger" or a "threshold trigger". With a time trigger, you rebalance your portfolio at set intervals of, say, once a year or more frequently. And with a threshold trigger, you rebalance when your portfolio drifts from its asset allocation targets by a predetermined percentage.
  • Minimise rebalancing costs: Keep potential tax and transaction costs of rebalancing to a minimum. Some investors use cash where possible – perhaps from dividends and savings accounts – to replenish asset classes that have become underweight over time. Those with investments inside and outside superannuation should keep in mind when rebalancing that their super savings are either concessionally-taxed or exempt from tax.

The rebalancing of a portfolio can seem counter-intuitive. This is because rebalancing requires the selling of currently outperforming assets to buy currently underperforming assets.

*The global case for strategic asset allocation and an examination of home bias, Vanguard 2017.
**Getting back on track: A guide to smart rebalancing, Vanguard 2019.

 

Written by Robin Bowerman, Head of Corporate Affairs at Vanguard.
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Robin Bowerman, Head of Corporate Affairs at Vanguard Australia, shares investment and personal finance insights gained from over two decades in the finance industry as writer, commentator and editor.

Robin Bowerman