Rebalancing Your Clients' Portfolios: Best Practices

Posted by Brian Glazer

September 8, 2015 at 10:00 AM

rebalancing your clients' portfoliosLarry Swedroe, noted financial author and director of research for BAM Advisor Services, once wrote, "Rebalancing, or the process of restoring a portfolio to its original composition, is integral to the winning investment strategy. It requires you to buy what has done relatively poorly (at relatively low valuations) and sell what has done relatively well (at relatively high valuations)." Put another way, rebalancing investments involves bringing a portfolio that has deviated from your client's investment objective or target asset allocation back into line.

But how should you actually go about rebalancing your clients' portfolios? Here, I'll take a look at some best practices, including the how, why, and when of making the rebalancing decision.

How Can You Rebalance?

First, let's discuss how you might rebalance a portfolio:

  1. Sell investments in an overweight asset class and use the money to buy investments in a class that is underweight
  2. Add or remove money from the portfolio (i.e., put new money into an underweight class or make withdrawals from an overweight class)

But is it truly worth the time to rebalance your clients' investments at both the account and household level?

3 Reasons to Rebalance

When thinking of why you should rebalance, consider some of the benefits:

1) Lock in gains. Rebalancing locks in gains on appreciated investments. Your clients may think, "Why should I sell my winners?" but there's nothing wrong with taking a profit. After all, you don't actually make money on paper gains; you make money when you sell. You're not selling out the entire position, of course—just some of it. The client still has skin in the game and will profit if the existing position continues to appreciate.

Momentum investing strategies—based on the idea that winning investments will continue to win (and losers to lose)—may sound appealing. But if you've ever looked at the Callan Periodic Table of Investment Returns, you know that no investment style or asset class stays in favor forever. As an investor, it's as hard to pick a top or sell point for an investment as it is to pick a bottom or buy point.

2) Fund retirement withdrawals. Rebalancing can also be a helpful tool in retirement income planning, particularly during the withdrawal phase. For advisors using the bucket approach, retirement income planning specialist Michael Kitces suggests selling your "winners" out of various buckets to fund needed client withdrawals and buying more of the "losers" from your other buckets. Kitces's data shows how this approach, compared with selling your winners and not buying more losers, can help avoid common risks in retirement (e.g., sequence-of-return and longevity risk).

3) Reduce risk. Perhaps most important, the rebalancing process helps reduce risk by maintaining your client's original investment objective and risk profile. Since 2008, many advisors have used alternatives for downside protection in their clients' portfolios. Another way to achieve such protection is to take some risk off the table when the markets are up and add risk when the markets are down. Rebalancing can help reduce the emotional component of investing, encouraging clients to buy low and sell high: It provides both structure and discipline in the investing and asset allocation process.

Best Practices

When should you rebalance your clients' portfolios? Although much depends on the individual client's situation, there are some general rules and best practices to keep in mind.

Trigger strategies. A 2010 Vanguard study, Best Practices for Portfolio Rebalancing, analyzed three triggers that can be used to initiate a rebalancing event:

  1. The "time-only" strategy is based on calendar dates (e.g., monthly, quarterly, at client reviews). The frequency depends on:
  • Investor risk tolerance
  • Correlation among the portfolio's assets
  • Rebalancing costs
  1. The "threshold-only" strategy requires daily monitoring to determine when predetermined thresholds have been breached.
  2. The "time and threshold" strategy is a combination of the first two methods.

The study found that, for most investors, annual or semiannual monitoring with rebalancing at 5-percent thresholds is likely to produce a reasonable balance between risk control and cost minimization.

5/25 rule. Another useful guideline is Larry Swedroe's 5/25 rule, which he explains in the book Think, Act, and Invest Like Warren Buffett: "Rebalancing should occur only if the change in an asset class's allocation is greater than either an absolute 5 or 25 percent of the original target allocation, whichever is less."

  • Example 1: A client's portfolio is 70-percent stocks and 30-percent bonds. If stocks drop in value, the allocation may shift to 65-percent stocks and 35-percent bonds. To rebalance, you should buy 5 percent in stocks using the proceeds from selling 5 percent of the bonds.
  • Example 2: For subasset classes that have smaller allocations, you'd apply the 25-percent criterion. If the client has a 10-percent allocation to small-cap stocks, for example, you would buy or sell when the allocation goes down to 7.50 percent or up to 12.50 percent. (The 2.50-percent tolerance band comes from multiplying 25 percent times 10 percent.)

Managing expenses. Generally, it's a good idea to have wider corridors or drift tolerances for illiquid investments like real estate and private equity, as these asset classes tend to have higher transaction costs. Rebalancing can often generate excess transaction charges, and you may need to base rebalancing frequency on the account size.

Taxes and Other Considerations

Because selling assets can generate capital gains and losses, taxes are a big consideration in the rebalancing decision. It's key to understand your client's tax situation and give yourself time to offset any gains before year-end. It's advisable to have wider corridors for taxable accounts than for qualified accounts. A general guideline is to rebalance when the benefits outweigh the costs.

Some other key factors include:

  • Alternative investments, including assets like real estate, managed futures, and hedge funds, can pose a rebalancing challenge. You may have to reallocate around some of these illiquid asset classes.
  • Decide whether to reinvest dividends, have them go to cash, or sweep the account. By choosing the cash option, you may be able to use the money to balance out asset classes and avoid selling off winners.
  • Withdrawals can throw off your allocation. Try to plan ahead and leave money in cash to cover foreseeable withdrawals and your advisory fee. When you need to raise funds for a withdrawal, consider selling off overweight positions to bring the portfolio closer to the recommended allocation.

Peaks and Valleys

A structured rebalancing process may take some time to set up, but it's a great way to reduce emotion-based decisions and help your clients stick with their investment plan. Ultimately, implementing a rebalancing process—and educating your clients about it—should reduce panic selling and fearful investing, helping everyone sleep a little better at night.

Have you established a set schedule or process for rebalancing your clients' portfolios? Has it helped alleviate your clients' emotion-based financial decision making? Please share your thoughts with us below.

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