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Money Matters


By Mary Lynne Dahl, Certified Financial Planner ™


December 09, 2020
Wednesday AM

jpg Money Matters by Mary Lynn Dahl

Mary Lynn Dahl

(SitNews) Ketchikan, Alaska - Investors who are more successful use tested and proven strategies to get better performance. One of those strategies, used by professional financial advisors as well as smart individuals, is called rebalancing. This strategy has long been shown to improve long term investment performance as well as reduce risk. It is related to the concept of diversification but is different in several ways. This article will explain the concept of rebalancing a portfolio.

First, understand that you need a goal for any portfolio. Let’s say that your goal is retirement, 10 years away, at which time your portfolio will need to provide you with income that will replace a specific percentage of your earned income from working.

You should also have an asset allocation strategy, so let’s say that you have your portfolio divided into 10 categories. Example: 1. US large company stocks, 2. US mid-size company stocks, 3. US small company stocks, 4. foreign stocks, 5. tech stocks, 6. health care stocks, 7. transportation stocks, 8. real estate stocks, 9. clean energy stocks and 10. bonds (hypothetical example only).

Let’s also assume that you started this portfolio with $20,000 invested in each of these 10 categories, for $200,000 in total. This strategy uses 10% of each category as the weight of that category. You can vary the weight among the 10 categories, but to keep the math easy, we will assume 10% for each category in this example.

So, since the start of the portfolio 1 year ago, the categories have grown with gains in value, dividends and a little interest. Some categories have grown much more than the others and perhaps one or more has not grown as much. The result is that the portfolio is no longer approximately 10% in each category. In this example, let’s assume that the tech stock category has grown by 30%, the health care has grown by 20%, the clean energy has grown by 15% and the others have grown by 9% except that the bond category has only grown by 3%. Since your original design was that each category would make up 10% of the total, the portfolio is now “unbalanced”. Is this a good strategy?

Generally, being unbalanced is not the best strategy to use. Putting it back into balance will increase the potential performance and reduce the potential risks. So how should this rebalancing be done?

To rebalance, start with a look at each category to decide if you want to keep it as part of the allocation strategy. Let’s say that you do agree, so these 10 categories will remain. None will be eliminated and no new categories will be added. So, with the 10 categories, the goal is to get each one back to a value of approximately 10% of the total.

Normally you would keep some amount in cash but we are not including cash as a category in our example, to keep the math simple.

The way to rebalance the portfolio is to sell off enough shares of those categories whose value exceeds 10% and buy shares of those categories that are worth less than 10% so that the value of each category is about 10%.

In our example above, you would sell shares of the tech stock category, the health care category and the clean energy category. With the cash from these shares sold, you would buy shares in the remaining 7 categories to bring each category up to a value of about 10% of the total portfolio. This brings your portfolio back into balance. It also reduces your risk significantly and generally improves the total return of the overall portfolio over longer periods of time.

This strategy has shown time and time again that it is superior to just letting your portfolio grow at varying rates for each category or each investment fund you hold in the portfolio. It is, however, not intuitive for most people. It “feels” wrong to sell shares of a fund or category that has outperformed other categories because you are selling your winners, so many people are not emotionally able to do it. Notice that I am not suggesting that you sell all shares of those categories that performed best. You still keep them, but at 10% of the total, not more.

Long term studies on return and risk have proven that it works very well, so it is used by smart individual and professional investment advisors. In addition, with the advances in technology that are being used by many investment advisor firms, portfolio rebalancing is increasingly available in computer generated programs that automatically rebalance for an investor client as often as the client wants to rebalance. Many of these algorithm programs offer rebalancing as often as daily, but more likely monthly, quarterly, semi annually and annually.

That leads to a question I have frequently been asked by clients who want to rebalance but have not decided how often they want to do it. I initially was not sure myself, so about 15 years ago I gathered data to learn what frequency of rebalancing is the most effective. The variables that influence how often to rebalance are risk, return and cost.

In most rebalancing plans, the categories are first chosen and usually are not changed over short periods of time unless there is plenty of data to suggest that a category should be removed from the total list of categories being used. Assuming this is the case most of the time, it turns out that the optimum schedule is annual rebalancing, not more frequently. My research in more recent years has confirmed that the data still favors annual rebalancing as the most cost efficient plus the most effective in producing better returns at less risk. Not much has changed in the years since I first looked at the data on rebalancing.

Deciding when to rebalance should be discussed with your tax advisor prior to the rebalance, as selling shares that have grown in value will trigger a capital gain if the portfolio is taxable. In that case your tax advisor will want the rebalance to be at least 12 months plus 1 day so that the gain will be subject only to long term capital gains tax, not short-term gains or ordinary income tax. Currently, long term capital gains tax is much less than the tax on ordinary income. If this is the case in your portfolio, have a conversation with your tax advisor before doing the rebalance.

If, however, your portfolio is not taxable, like in a 401-k, an IRA or a SEP (or other qualified retirement plan), there is no impact on your taxes, so schedule the annual rebalance for whatever month is most effective for your own financial planning purposes. For a lot of people, that is December, but for many others it is January. Regardless, this strategy, while not used by enough investors, is powerful and effective at the overall long-term goal of getting better portfolio returns at slightly less levels of risk than simply shooting from the hip and allowing the different asset categories in the portfolio to grow at varying and unequal rates of return.

Investing is not gambling. It is not a game of chance. Do not think of it as either. Realize that it is plan to accumulate enough assets to replace income and cover expenses, assets that can and do grow in value, pay dividends and interest. Doing a good job of accumulating enough is an art and a science, with proven strategies and techniques that are key to long term investment success. Rebalancing is one of those powerful keys. As we approach the end of 2020, consider it for your own portfolio.



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©2020 Mary Lynne Dahl, CFP® is a Certified Financial Planner ™ and partner in Otter Creek Partners, a fee-only registered investment advisor firm in Ketchikan, Alaska. These articles are generic in nature, are accepted general guidelines for investment or financial planning and are for educational purposes only.

Mary Lynne Dahl ©2020

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