One of our jobs as your professional investment management team is to keep your portfolio in balance. What does that mean? When we start working together, our Investment Policy Statement represents our job description. It outlines your personal asset allocation and requires us to stay within a defined band on each side of the allocation for each asset class.
These percentages can go awry because one asset class does better than another. Since stocks have a higher expected return than bonds, we usually anticipate the equity allocation will exceed its target. When this happens, a rebalancing is necessary – moving funds into the lower performing class to bring allocations back to the IPS levels. This results in selling high and buying low – always the objective, but not always the reality for many investors. There is no speculation on whether or not the asset class will continue to do well – market timing is not an efficient investment management strategy.
Interestingly enough, the 2008 equity markets caused allocations to be misaligned the other way – bonds outperformed stocks. Did we apply our rebalancing principles in those most unusual circumstances? The answer is yes. When the equity markets seemed to be free-falling, our conversations with clients were focused on holding the course we had set. We cautiously rebalanced while tempering the fear.
Other considerations come into play when looking at rebalancing. If a sale of assets is required, will there be capital gains tax issues? Alternatively, can cash flow into the portfolio be used for rebalancing rather than triggering a sale? Cash flow can be in the form of income from investments held, or new funds being deposited. This is one of the reasons we often have income distributions paid in cash rather than reinvested within our portfolios.
The IPS is a basic roadmap for your investment management. At PWL, our job is to ensure you stay on track and rebalancing is an important part of the risk management within your portfolio.