Contributed by: Center Investment Department
An investment strategy that uses asset allocation must rebalance, or realign the weightings of the portfolio assets; the question is not if, but how. Rebalancing is a type of active portfolio management strategy we employ either to potentially enhance returns, control risk, or both. There are several ways to rebalance a portfolio: on a calendar basis, using cash flows, and opportunistically. We utilize a combination of Cash Flow and Opportunistic rebalancing.
Calendar rebalancing is done by choosing a specific date (usually arbitrarily such as on a quarterly, semiannual or annual basis) to rebalance portfolios. Studies have shown that there is not much performance differential between the different frequencies of rebalancing. By utilizing a set calendar date to rebalance, often the best buy-low/sell-high opportunities are missed.
Cash Flow Rebalancing
In contrast, cash flow rebalancing is prompted when cash is moving into or out of the accounts. For example, if a cash distribution is needed, the asset category or categories that are the most overweight will be sold to raise cash. Within the overweight asset category, we will sell the security with the lowest preference first to generate the needed cash. If cash is flowing into the account, we will purchase the asset category or categories that are the most underweight. Within the underweight category, we will purchase the security with the highest preference first. Security “preference” is determined opportunistically within our investment committee.
When an asset allocation is determined after the financial planning and risk assessment, a set of drift ranges are also assigned. The highest level strategic allocation (i.e., stocks to bonds) is allowed to drift a total of 10% either direction from the overall target. On a more granular level, each asset category is allowed to drift 20% in either direction. For example, if the US Large Cap allocation is at 25% of the portfolio, it could drift to as low as 20% or as high as 30% of the portfolio before rebalancing would occur. The idea behind this is to help your winners continue to grow before you are flagged to rebalance and “sell high”/”buy low”. This can also be referred to as range or threshold rebalancing. Range rebalancing occurs when at least one asset category is outside of the range bands. At this point, the out of tolerance band is brought back to target.
Rebalancing is an important tool for long-term investors to stay on course. A Financial Planner can help you employ these more sophisticated strategies outlined above!
Daryanani, Gobind CFP®, Ph.D.”Opportunistic Rebalancing: A New Paradigm for Wealth Managers.” 2008. Journal of Financial Planning.
Rebalancing a non-retirement account could be a taxable event that may increase your tax liability. Illustrations have been provided for educational purposes only and are not intended as investment advice. Investing involves risk, investors may incur a profit or loss regardless of the strategy or strategies employed.
The information contained in this blog does not purport to be a complete description of the securities, markets, or developments referred to in this material. The information has been obtained from sources considered to be reliable, but we do not guarantee that the foregoing material is accurate or complete. Any opinions are those of the professional of the Investment Department at The Center and not necessarily those of Raymond James. Every investor's situation is unique and you should consider your investment goals, risk tolerance and time horizon before making any investment. Prior to making an investment decision, please consult with your financial advisor about your individual situation. Future investment performance cannot be guaranteed, investment yields will fluctuate with market conditions.