Download Portfolio rebalancing: Why it`s important, what to consider

Portfolio rebalancing: Why it’s important, what to consider
Paula Fuchsberg: Hello, and welcome to Vanguard’s Investment Commentary Podcast
series. I’m Paula Fuchsberg. In this month’s episode, which we’re recording on February
17, 2016, we’ll talk about best practices for portfolio rebalancing.
Meet the speaker
Joining me is Yan Zilbering, an investment analyst in Vanguard Investment Strategy Group
and coauthor of a recent research paper on today’s topic. Yan, welcome.
Yan Zilbering: Thank you, Paula. I’m excited to be here discussing this important topic.
Paula Fuchsberg: At the heart of your paper, Yan, is the premise that investors should
develop a rebalancing strategy during the process of building their portfolio. Why is such a
strategy important, and what’s the primary goal?
Yan Zilbering: Investors spend a lot of their time in putting together their investment plan.
And they pick an asset allocation that is in line with both their investment goals and their
tolerance for risk. However, we know that over time, portfolios tend to drift a little bit—or
sometimes a lot—as different asset classes produce different returns over time. And what
typically ends up happening is the riskier asset classes grow faster than the less risky ones
over an extended time horizon. So think about stocks really growing faster than bonds in a
portfolio.
And what ends up happening is that equity allocation or stock allocation in a portfolio, as
it grows, exposes the portfolio to greater market risk. And if markets were to correct, as
they have done this past January, what ends up happening is investors could panic and that
could cause them to really stop and abandon their investment plan, and that could possibly
jeopardize their chances of meeting their financial goals.
So the primary goal of rebalancing is to bring the portfolio in line with the target allocation
and acceptable risk level for that investor. And at that level, investors are more likely to
endure market volatility and stick to their plan.
Paula Fuchsberg: So what considerations should go into selecting a rebalancing strategy?
Yan Zilbering: Well, when selecting a rebalancing strategy, one should consider three
things: how often they want to rebalance, so how frequently the portfolio should be
monitored, whether it’s monthly, semiannually, annually; how far an allocation should be
allowed to drift—so do we want to let the portfolio drift by 5%, or is it 10%? And how
much? And what I mean by that is, when we rebalance, should we rebalance back to the
original target allocation, or maybe to some reasonable range that’s closer to target but
maybe not the exact target allocation?
Paula Fuchsberg: So given those considerations, how might an advisor or investor best
determine the right time to rebalance?
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Yan Zilbering
Investment Analyst
Vanguard Investment
Strategy Group
Yan Zilbering: Well, the right time to rebalance is very different for everyone. Some investors
are very sensitive to risk, and they may want to choose to rebalance more frequently or have
a very tight threshold for their allocation. [For] those investors, our primary concern would be
their target allocation and keeping the risk in check.
For others, maybe costs are primary considerations. Maybe they’re not as concerned as being
as precise on the asset allocation, so maybe they’re considering the costs of the transactions
involved with rebalancing or maybe the taxes that may be incurred.
For those particular investors, maybe having a wider threshold, say, 5% or 10%, is more
reasonable. Or perhaps they monitor it on a less frequent basis, say annually. Regardless of
the strategy, what is important is that up front, the investors determine what that strategy is
and really sticking to it. This will really help keep an investor disciplined through times when
markets may be a little bit volatile.
Paula Fuchsberg: And more broadly, what did you conclude about how often a portfolio
should be rebalanced?
Yan Zilbering: Well, in our research we looked at three different strategies. One was a timeonly strategy, where a portfolio is rebalanced on a predetermined time schedule, so whether
that’s monthly, semiannual, or annual. So once you hit that time frame, you really rebalance
the portfolio.
The second strategy that we looked at was threshold only. And what an investor does in
that strategy is really monitor the portfolio on a daily basis, and if the portfolio drifts by a
predetermined amount, like 5% or 10%, they rebalance their portfolio at that point.
The third strategy, the one that we would suggest, is merging the two. It’s really incorporating
monitoring the portfolio in a predetermined frequency, so it’s a time-and-threshold strategy.
So we’d monitor the portfolio on a quarterly basis, semiannual basis, whatever we choose it
to be, and then only rebalance if the portfolio has drifted beyond our predetermined threshold,
so 5% or 10%.
What’s interesting about comparing those three strategies in our research is we really found
no significant differences between any of the strategies. Whether you rebalance quarterly,
semiannually, or annually, whether your threshold is 5% or 10%, there was really no
meaningful difference in your outcomes. Historically, there hasn’t been, at least.
But what we did find was that there was meaningful difference between portfolios that were
rebalanced and ones that were not. And what we found was those portfolios which were
not rebalanced historically have really grown in their equity allocation, and with that came
substantially more volatility in those portfolios, and it creates really higher probabilities of loss
for a portfolio.
So after taking all of those into consideration, we thought that for many investors, a
reasonable strategy would be to look at a portfolio on a semiannual or an annual basis and
rebalance when it drifts by 5% or so.
Paula Fuchsberg: Yan, your paper notes that rebalancing can be an emotional decision and
can even seem counterintuitive at times. Can you explain that?
Yan Zilbering: Sure. I’ll explain what we mean by counterintuitive. If you think about
investors, when they’re looking to buy a fund, for example, they look at maybe past
performers and they find those funds that have done well in the recent past. Or if they’re
holding a fund which hasn’t performed well, maybe they’ll sell that particular fund. That
seems very intuitive to them.
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We’ve observed this type of investor behavior in the past, and our research suggests that
maybe that’s not the right way to do it. That’s a whole other topic that I’ll leave for another
day. But when we’re talking about rebalancing, we’re really flipping that on its head. And what
we’re saying is, we’re selling those assets which have appreciated in value, and we’re buying
those that have either lagged or depreciated.
So it seems a little counterintuitive. If we’re in a bull market and equities are going up, what
we’re saying is you have to sell some of your stocks to buy the bonds. It could be very
emotionally difficult to do so, and rebalancing could be a strategy that could keep you on track
and remove that emotion from it.
Paula Fuchsberg: Do you have any suggestions on how advisors should approach or position
rebalancing with their clients?
Yan Zilbering: Yes, Paula. This is an excellent question because despite rebalancing seeming
like it’s an easy thing to do, it is very emotional. It’s difficult. We know that investors don’t
rebalance. If we look at industry trends, we see that investors tend to buy and hold, so to
speak. So the portfolios tend to drift as the market goes up. So their equity allocation drifts
upward. And vice versa—when markets are correcting or we’re in a prolonged downward
market, we see that equity allocations and portfolios drift downward.
So while investors know about rebalancing, they find it very difficult to do. And this is exactly
where an advisor can come in and act as that emotional circuit breaker. Advisors can step
in, separate the emotion out of it, and really execute on the investors’ plan and help them
achieve their goals.
Paula Fuchsberg: And is there anything you would advise investors to keep in mind to help
them stick with their strategy?
Yan Zilbering: Yes. Investors should think of rebalancing as a discipline strategy. So it’s really
a strategy that helps them stay the course and stick to their investment plan.
So in the process of putting together their financial plan, if they determine what rebalancing
strategy is best for them, then they can write it in. And later, when it is difficult or emotionally
difficult to make the decision to rebalance, they can actually just execute, because it’s already
in their plan.
So if they think about rebalancing as a strategy that helps reduce the risk of their portfolio to
a more comfortable risk level that they have chosen at the onset of building their portfolio, it
can really, down the line, help them stay the course and meet their financial goals.
Paula Fuchsberg: Well, Yan, you’ve given us a lot of important insights. Thanks so much for
joining us today.
Yan Zilbering: Thank you very much, Paula. It’s been a pleasure.
Paula Fuchsberg: And we hope you’ve enjoyed this Vanguard Investment Commentary
Podcast. Be sure to check back with us each month for insights on the markets and investing.
And, remember, you can always follow us on Twitter. Thanks for listening.
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The research cited throughout this podcast is taken directly from the paper titled Best practices for portfolio rebalancing,
available at vanguard.com.
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