A brief discussion of the pros and cons of automatic portfolio rebalancing.

Rebalancing: Pros & Cons

By J. Andre Weisbrod

            Rebalancing is the periodic reallocation of asset types in a portfolio to conform to a pre-set allocation percentage for each asset type.

            Let’s say you were comfortable with a balanced portfolio that had 30% bonds and the rest in stocks.  If stocks go down and bonds go up, your allocation could become 42% bonds and 58% stocks.  Rebalancing will switch enough bonds into stocks to bring your allocation back to your original settings and will result in your selling high and buying low, which is a time-honored basic principle of successful investing.

EXAMPLE:

            If the rebalancing occurs at the right time and stocks go back up, the change will increase your “buy and hold” return.  However, if stocks continue downward, it will decrease your return.

What are the advantages of Rebalancing?

            As stated above, rebalancing forces you to sell something that has gone up and buying what goes down.  In general, this should reduce volatility depending on the time periods between rebalancing.  It may or may not enhance returns depending on what the markets’ actual behavior is.

What are the disadvantages of Rebalancing?

            In non-qualified taxable accounts, every sale (redemption) of a fund causes a “tax event” (a gain or loss) that needs to be reported on your taxes.  Rebalancing can make tax time more complicated.  Therefore many people will choose to set up auto-rebalancing programs only in qualified retirement accounts or tax-deferred accounts where transactions do not cause tax events.

            If one market continues to rise while another continues to fall, your performance could be hurt.  Rebalancing would keep taking out of the investment that is doing well and putting it in the one that is doing poorly.

            The success of rebalancing depends in large part on the time frames chosen for the automatic rebalancing to take place.  Typically, investors choose quarterly or annual rebalancing, though other time frames are possible.

            Finally, if you are using an asset allocation approach that assumes average returns over long periods of time for planning purposes, rebalancing will invalidate the long-term statistical basis for return expectations based on history.

The STAAR Approach

            We do not employ automatic rebalancing.  Rather we evaluate the need for portfolio changes by consider the following factors:

1. Client Objectives: Is the overall allocation within the Objectives and Risk Tolerance of the client?
2. Overall Economic and Market Trends:  If trends are favorable, increase allocation toward areas of strength.  Conversely if trends are unfavorable, decrease exposure in those areas.  “The trend is your friend.”
3. Risk Assessment: If we see increased risks, we will be inclined to get a bit defensive.
4. Contrary Opportunities: If there has been a big sell-off or a long bear market, look for opportunities to buy.  If the markets or a particular sector or stock have been soaring, take some profits.

Any one or all of these can cause us to change a portfolio mix.  Note that we are not “market timers” who often move large amounts or entire portfolios in and out of markets on short-term basis.  We practice what we call “Incremental Portfolio Adjustment” within a long-term asset allocation approach.

Copyright 2008,  STAAR Financial Advisors, Inc.