Importance of rebalancing and asset allocation

Travis Gallton, The Daily Record Newswire

With the current volatility in the financial markets, it is a great time to revisit your long-term asset allocation decisions and whether they are able to meet your return objectives. Defined, asset allocation is a process of balancing risk and reward to each asset class to match an investor's return goals, risk tolerance and investment time frame.

In 2000, Ibbotson and Kaplan studied the importance of asset allocation and published "Does Asset Allocation Policy Explain 40, 90, or 100 Percent of Performance?" They concluded that 40 percent of the variation of returns was attributable to asset mix choices (i.e., stocks, bonds, and alternative investments).

With the virtual disappearance of defined benefit plans (pensions) and the emergence of most companies offering defined contribution plans (e.g., 401(k) or 403(b) plans) employees have become more and more responsible for their investment success. In fact, according to the Employee Benefit Research Institute, by the year 1990, defined contribution plans topped the percentage size of defined benefit plans in the private sector.

Compared to the past where employers played a large role, employees now bear all investment risks for choosing their appropriate asset allocation, as well as the responsibility for ensuring their portfolio is rebalanced on a periodic basis.

Often, when individuals begin to invest in their 401(k) or 403(b) plan, they select their asset allocation depending on their risk tolerance and return expectations. However, as time passes, the market can cause an individual's original asset allocation to drift away from their original allocation mix. This can negatively impact their ability to meet their stated objectives. Rebalancing is what many individual investors typically forget to take action upon.

To illustrate the risks of not rebalancing, I have included a table as if your portfolio was allocated 50 percent in the average domestic equity mutual fund and 50 percent in the average fixed income mutual fund. As the table shows, if you do not rebalance, you unknowingly assume more equity risk than previously planned.

Impact of Not Rebalancing

Original Allocation:

3-Years 5-Years % Equity

50.0% 58.0% 62.1%

Fixed Income:

3-Years 5-Years % Equity

50.0% 42.0% 37.9%

To combat this risk, there are various options investors can take when it comes to rebalancing. Most individuals prefer to use a calendar rebalancing technique. Calendar rebalancing is where an investor rebalances back to a strategic allocation on a pre-determined basis, i.e. monthly, quarterly or yearly. The obvious benefit is that it provides discipline without investors having to constantly monitor the market. However, the main drawback could be large oscillations among asset classes between your rebalancing dates.

Another technique to use is to rebalance on a target percentage of the portfolio (PPR). The PPR technique is where individuals rebalance based on a threshold or a tolerance band for an asset class, e.g., a range of a certain percentage. The optimal tolerance band is typically determined by a client's risk tolerance, transaction costs involved, and the tax liability the investor could incur.

The primary benefit of PPR rebalancing is that it tends to minimize the degree of shifts in various asset classes by locking in gains. Alternately, the main drawback is that investors must constantly monitor the market. Institutional investors and active managers are more likely to use the PPR strategy as they will make tactical active tilts from the strategic asset mix depending on current market conditions.

As the discussion here shows, it is important for investors to periodically revisit their asset mix and rebalance not only due to changed circumstances of the investor's life, but also due to the effect of passage of time and market movements. Rebalancing allows investors to maintain their desired exposure to a desired asset mix (desired risk factors), provides a discipline, teaches investors to stay focused, and enhances returns and reduces risk over a long-term horizon.

If you are unsure of how you should approach the issue of rebalancing your portfolio, speak with an investment advisor to further understand your options on this forgotten, but key element in achieving your investment objectives.


Travis M. Gallton, CFA, is a senior equity portfolio manager for Karpus Investment Management, a local independent, registered investment advisor managing assets for individuals, corporations, nonprofits and trustees. Offices are located at 183 Sully's Trail, Pittsford, NY, 14534; (585) 586-4680.

Published: Mon, Sep 21, 2015