Deliberate Portfolio Rebalancing
An investment portfolio should be allocated to provide the risk/return profile that meets the investor’s needs in support of his or her financial goals, risk tolerance, and investment time horizon. This allocation strategy can be developed with an understanding of the probabilistic expected return and market covariance for each asset class in order to construct a portfolio that accounts for these characteristics to align with the investor’s needs.
Once the portfolio is constructed and implemented, the concept of portfolio rebalancing becomes a critical element in ensuring that the portfolio remains on track to accomplish its intended purpose. The two most commonly employed asset classes in an individual investor’s portfolio, stocks and bonds, have prices that tend to move in opposite or at least less-than-perfectly-correlated directions and magnitudes. Because of this price relationship, a portfolio may experience price movements that cause relative asset class allocation weights to diverge moderately or drastically away from the ideal target allocation, resulting in a portfolio risk/return profile that no longer aligns with the needs of the investor.
For example, albeit an oversimplified one, a portfolio that was constructed to hold 80% stocks and 20% bonds may, in the middle of a sharp market downturn, end up with an allocation of 35% bonds and 65% stocks. In order to realign the portfolio allocation with the investor’s goals, risk tolerance, and time horizon, the portfolio should typically be rebalanced to return to the target allocation weights. Portfolio rebalancing often indirectly introduces the benefit of selling at relatively higher prices and buying at relatively lower prices. In a bear market where stock prices drop and bond prices increase, for instance, the action of rebalancing sells the relatively more expensive bonds and uses the proceeds to purchase relatively less expensive stocks, to the benefit of the investor.
Portfolio rebalancing should not be limited simply to relative allocation weights of stocks and bonds. Subsets of these asset classes also have varied characteristics that can produce differentiated returns. These varied characteristics can be researched, understood, and utilized to maximize the benefits of diversification. Such characteristics include, but are not limited to: company size, geographic region, and industry. Each characteristic can impact returns differently depending on context, so it’s important to ensure that a portfolio does not become too overweight toward one category or too underweight on another.
Consider a portfolio holding equity in companies that are in the travel industry (e.g., airlines and cruise lines) and also equity in companies in the fossil fuel industry. Both investments are in the stock asset class, but they can experience vastly different financial performance, even at the same time and under identical economics conditions. If the price for a barrel of oil doubles in a given year, an upstream oil company may realize an exceptional increase in revenue, profit margins, and earnings, likely resulting in a corresponding appreciation in stock price. Meanwhile, an airline that purchases oil as a major proportion of its business expenses and has limited oil hedge contracts to protect against a surge in oil prices, may suddenly find itself with skyrocketing costs, squeezed profit margins, and a potential cash shortage, likely resulting in a corresponding decrease in stock price. That’s just one example of how different characteristics, even within the same asset class and in the same economic environment, can result in very different investment returns. Accordingly, a thoughtful approach to portfolio rebalancing should account for maintaining target allocations across diversified market capitalizations, geographic regions, industries, and other characteristics.
Within the appropriate parameters of a customized portfolio allocation strategy, an investor should take care not only to diversify across asset classes and various investment characteristics, but also to rebalance at regular intervals to ensure that appropriate allocations are maintained. This enables a portfolio to align with the investor’s goals, risk tolerance, and time horizon, and to provide a true benefit that improves financial security and quality of life.
