Rebalancing your portfolio

Rebalancing your portfolio

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Pretty well all investors understand that investment success entails buying (relatively) low and selling (relatively) high.  The difficulty that we face is that it is never obvious until after the event whether the value was low or high at a particular point in time.  Clearly, the optimal strategy would be to buy assets only when they are cheap and sell them only when they are expensive.  However, doing this consistently is extremely difficult if your measure of whether a price is high or low is based on its price relative to some other variable.

Fortunately, there is a way of using the relative value of assets which does not require any ability to predict the future.  As we move into the time of year in which most of the trading activity in our portfolios tends to happen, this is as good a time as any to cover the subject of portfolio rebalancing.

What is rebalancing?

To put it simply, rebalancing is the process of adjusting the composition of a portfolio from where it is now to some other composition.  In the case of our clients, the latter is the one which their financial plan suggests is the one most likely to enable them to achieve their goals with an acceptable degree of risk along the way.

I will not describe here the process by which this optimal portfolio split is determined but it involves collating as much information as possible about their financial goals, willingness and ability to accept risk, assets, liabilities, income and expenditure and how they expect these to vary during their lifetime.  One of the outcomes of this is an indication of the lowest risk split between growth and defensive assets whose long-term expected return would be sufficient to meet all of their goals.

Having agreed on this split and invested their assets accordingly, it might appear that it would now be a case of sitting back and waiting for capital markets to do their thing over the coming decades and only looking at the portfolio when cash needed to be added to or withdrawn from it.

Why does it matter?

However, not only do investment prices not remain static, not all investments rise and fall at the same time all by the same amount.  This is at the heart of the principle of diversification.   Those of us not blessed with an ability to foresee the future accurately can hedge our bets by owning as wide a range of assets as possible.  At any given time, at least one component of the portfolio will probably be moving in a different direction to the others.  Since it is not straightforward to predict which will move in which direction and when, holding a spread allows participation in the returns of each asset.

While the first quarter of 2020 is merely the most recent example, history is littered with times in which markets reacted sharply to new and unexpected news and this obviously impacts on investors’ portfolios.  However, even while values were plummeting last year, in a diversified portfolio not everything was going down at the same rate.  Although our clients’ portfolios did fall in value, most did so by considerably less than they would have done had they been exposed to the full force of the sell-off of equities.

This was due to the exposure that they hold to defensive assets in the form of high quality fixed interest holdings.  While equities were falling, these bonds were doing their job and maintaining their value, even though in the long term we would expect the growth assets to outperform them.  The consequence of this difference in performance was that those portfolios which held both types of asset, as most did, had now diverged significantly from the long-term asset allocations which we had agreed with each client.  The chart shows such an example with two rounds or rebalancing, the first after an equity market fall and the second after its recovery.

Source: Bloomsbury Wealth

At the time, clearly nobody had a reliable idea of what was going to happen next but with the weights of a number of assets having diverged significantly from their targets, we rebalanced all clients’ portfolios to bring them back into line.  As it happened, this actually took place in the week in which equity markets pretty well reached their lowest level.  Although we did not know this at the time, it turned out to be the optimum time to be buying growth assets as have they remained on a rising trend (despite a few bumps) ever since.

Consequently, as we move into the part of the year when we would normally be ensuring that our clients’ affairs are in order for the end of the tax year in April, we are now engaged in a further round of rebalancing in which we are disposing of growth assets and purchasing more defensive ones to bring the portfolios again back into line with what each client has agreed.

When to rebalance?

While it is possible to rebalance monthly, weekly or even daily, the theoretical desirability of this has to be balanced against the practicalities of it (there is a delay between disposing of units in a fund and receiving the cash with which to purchase something else), which imposes an effective limit.   It is also important to consider the cost of transactions, which can outweigh any benefit if not kept under control.   For these reasons, we tend to rebalance only when cash is added or withdrawn or when the prices of the assets held have moved substantially.   For most investors managing their own portfolios, annually is certainly adequate to capture the long term fluctuations.


The most important aspect of rebalancing is simply to decide on the basis on which it will be done and then to do it.   In times of market stress, like early 2020, our emotions work against us.   They make it hard to sell something which has held or even increased its value just so that we can buy something which is falling.   Yet this is precisely the time at which rebalancing is most useful.   In the even more extreme conditions of 2007-09, we were rebalancing monthly and it was hard but it worked.   From speaking to other planners at the time who did not operate on a discretionary basis, a number of clients were reticent to do the same and ended up missing out on the full benefit of the recovery when it came.

It’s important to retain focus on the achievement of your long term goals.   That is always helped by buying things more cheaply than the price for which you eventually sell them.   Given how difficult it is to pick the best times to do this, rebalancing according to a set of rules offers a practical solution to the problem of how to do it without needing a crystal ball.