By: Investor Solutions, Inc.
With all of the volatility in the market, does your portfolio keeping you up at night? Maybe its time to look at a simple, yet effective strategy to keep risk under control.
When you sit down with an advisor for the first time, they will invariably go through the process of determining what risk level makes sense for the client and then construct an allocation tailored to that person’s specific needs and tolerance for risk. Many Financial Advisors use an Investment Policy Statement that spells out exactly what variability can occur with their investment returns. Once the portfolio is formed, asset proportions will deviate from the target proportions as prices fluctuate. Left free to float, a portfolio can change into an allocation with distinctly different risk and return characteristics than a client may wish to stomach. To get back to a clients “sleep at night factor,” an advisor will utilize the powerful risk control strategy of rebalancing. Rebalancing refers to the change of a portfolio’s asset proportions to the target portions. This article will go through the benefits of rebalancing and how to minimize the costs associated.
One of the conversations I have most frequently with clients involves the performance of their portfolio. When equities are doing well and their portfolio has been on a run, the fixed income portion of the portfolio will usually have lagged behind and the portfolio is now over weighted in riskier assets. The logic some people employ here is “let it ride. Why would I want to sell while the market is running?” The problem with this is that their portfolio may be taking far more risk than they would have ever agreed to when the portfolio was set up. Whether the market would continue to go up (or down) is not known, but the risk control benefits of rebalancing back to the original allocation are a certainty.
Now the tricky part. If the client has assets in more than a tax deferred retirement account, income taxes can become a big obstacle to a rebalancing strategy. Although the short term returns in the market can be very uncertain, we do have a pretty good idea what the tax man will want. With taxes being a big potential drag on overall returns, an investor can greatly reduce this cost and still employ an effective rebalancing strategy.
In this area, a financial advisor can be of great help to a client having both tax-exempt and taxable accounts. By allocating investments with relatively high expected taxable distributions such as fixed income, large cap value and small cap to tax-exempt accounts the advisor can increase the expected after-tax rate of return. In addition, coordinated management of the two accounts will allow for rebalancing with reduced capital-gains taxes.
If taxes are too big an obstacle to rebalancing, but allowing the investments to drift off course isn’t desirable either, an investor’s optimal rebalancing tool may very well be their cash holdings. Most investors have income from work or large cash reserves sitting on the sidelines as a safety cushion. New flows of money are a simple means to maintain a target allocation without selling and incurring rebalance costs as well as a means to establish multiple costs basis for future tax lots. Conversely, investors who are taking regular distributions can use this as an opportune time to sell overweighed positions to maintain their target allocation.
As portfolio allocations vary in performance through time they drift apart and the risk dynamic of the portfolio changes. To guarantee that a portfolio’s risk and return characteristics remain steady over time, a portfolio must be rebalanced. Remember, the allocation you originally established was designed to get you to your goal with a high probability of success AND allow you to sleep soundly at the same time.