Why Rebalance Your Portfolio Asset Allocation?

by Mike Holman

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The Canadian Capitalist recently wrote about couch potato investing and Sampson left some interesting comments about rebalancing and passive investors. 

 Here are a few thoughts I have about portfolio rebalancing:

 1) The main reason I rebalance is to maintain a consistent risk level in my portfolio.  For example if I decide I want a portfolio made up of 60% equities and 40% bonds and then after a couple of years, the portfolio is 70% equities and 30% bonds, my portfolio is now riskier than I planned and I will want to rebalance back to 60% equities and 40% bonds.

 2) Asset allocation is not something that just couch potato investors do – every investor has an asset allocation and likely rebalances.  Of course if you have 100% equities, your asset allocation never changes, so no rebalancing is required.

 3) I’m not a believer that rebalancing (in any form) will increase returns significantly or at all.  It really depends on the market activity and an assumption that asset classes will “revert” to the mean. In some markets it will help – in other markets it will hinder.

 4) Rebalancing assumes that your different asset classes are not correlated.  In my case, I use a short term bond ETF for my fixed income – I’m fairly certain that short term Canadian bonds are not very correlated with various world equities. Even if they were, my asset allocation would never change much and I would have no need to rebalance

 5) Rebalancing can take many forms including tactical asset allocation.  The reason a lot of people like to use a specific rebalancing rule is because it makes things easier. I don’t have a firm rebalancing rule, but I will try to check my portfolio once a year and if the allocations are significantly out of what, I’ll rebalance.

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{ 8 comments… read them below or add one }

1 My Own Advisor

Rebalancing is an excellent thing to do – good post.

I think the main objective of this activity, for me at least, I want to ensure I keep my “balance” that aligns with my long-term investment goals.

2 Sampson

Hey Mike, great post.

Agree on most points. As you point out, my comments were not actually specific issues to passive portfolios – however, active investors do have a means of addressing changes in correlation among asset classes by picking the new winners.

I don’t suggest this method is either lower risk, nor does it yield better returns over the long run, but it is something I think about a lot, but haven’t dug deep enough to find any solution.

We try to be mechanistic in our rebalancing also. However, I have a ‘modified’ view of tactical allocation, not by using large shifts in allocation amounts, but by selecting more asset classes than the standard 4 product solution. When setting up the initial portfolio allocations, potatoes are making a ‘tactical’ choice. I know Dan posted a few months back about back testing all the variants of his posted portfolios, and its not clear there are advantages over the periods examined, but non-definitive doesn’t mean there isn’t a better way to do things.

I think often this debate gets so heated, at least among the blogging community, there isn’t much useful discourse. I think we all have to refine what we mean by passive vs. active and recognize what about the strategies may or may not work.

3 Canadian Capitalist

I simply rebalance when adding new money. I like it because you are automatically taking advantage of market advances (typically more of the contributions goes to bonds) and market declines (typically more money goes to stocks). But, as you point out, the strategy will lag in some markets.

4 Mike Piper

Just curious, have you ever written about your total allocation?

5 Mike Holman

@Mike

http://www.moneysmartsblog.com/canadian-couch-potato-portfolio-returns/

At least that is the theory. I’m still in the process of rebalancing. Made some buys today. :)

6 Mike Piper

Cool. Thank you. :)

And, if I had any cash on hand in an IRA, I’d be buying today too!

7 Mike Holman

@MOA – Ditto for me.

@Sampson – Thanks. And thank you for inspiring it.

You’re absolutely right that potatoes have to do some sort of initial asset allocation.

@CC – Yes, I use new money to rebalance as well.

8 The Wealthy Canadian

Before I purchased a few income properties, my asset allocation was roughly 43% fixed income/guaranteed investment vehicles and 57% equities.

More often than not, I employed a strategy similar to CC’s in that if I knew my portfolio was a little low on one side, I’d top up to balance things out when it came time to invest.

My asset allocation has since changed to about 21% fixed income/guaranteed investment vehicles and 34% equities. I have a 24-month plan to bring things closer to more conservative levels but it will take some time.

Portfolio re-balancing is important for me but I’m not an investor that is stringent to the point where if I don’t have exactly 40% of my overall allocated to guaranteed investment vehicles, I’m going to sell off some of my stocks or other assets.

As a business man & investor, I want to keep an open mind for opportunities that present themselves. With that being said, I have my own personal investment policy statement whereby my overall objective is to get to the point where I end up with 60% of my portfolio in fixed income & guaranteed investments vehicles.

There was a recent post on CC’s site that discusses tactical asset allocation, and found it interesting as well.

Nice post!

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