Vital to regularly rebalance your assets

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<TABLE border=0 cellSpacing=0 cellPadding=0 width=452><TBODY><TR><TD vAlign=top width=452 colSpan=2>Published September 26, 2009

</TD></TR><TR><TD vAlign=top width=452 colSpan=2>Wealth insights

</TD></TR><TR><TD vAlign=top width=452 colSpan=2>Vital to regularly rebalance your assets
This process will ensure that portfolios continue to best match long-term financial goals

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By LIM MENG TAT
DIRECTOR
RUSSEL INVESTMENT

<TABLE class=picBoxL cellSpacing=2 width=100 align=left><TBODY><TR><TD></TD></TR><TR class=caption><TD>Rebalancing naturally encourages the selling of expensive assets and the purchase of cheaper ones.</TD></TR></TBODY></TABLE>DRAMATIC volatility in the equity markets across the globe has caused some people to question whether adhering to their strategic portfolios and rebalancing rules still makes sense.
Here we take a look at what rebalancing is and why, especially in the current environment, it is important to maintain a disciplined rebalancing policy.
As markets move, so does the weight of each asset class in an investor's portfolio, potentially increasing the portfolio volatility or lowering the expected level of return.
To keep an investor's actual asset allocation close to its original strategic allocation, it is necessary to regularly rebalance the assets.
This process will ensure that portfolios continue to best match an investor's long-term financial goals. Reducing the unintended risk of drifting away from the long-term strategic asset allocation really pays off in times of high market volatility.
In essence, a passive rebalancing policy is designed to:
ensure that the market exposure of the portfolio is maintained in line with the strategic benchmark; and

take the emotion out of rebalancing decisions by instituting a mechanical approach to managing asset allocation shift.
Setting a strategic asset allocation
Defining a rebalancing policy is an important element of setting a strategic asset allocation within a portfolio. An investor's strategic asset allocation - the percentage allocated to the major asset classes such as equities, fixed interest and alternatives - is the principal determinant of a portfolio's long-term investment performance.
The strategic asset allocation determines the amount of risk taken and the returns an investor is likely to receive. According to a well-known publication by Brinson, Singer and Beebower in the Financial Analyst Journal ('Determinants of Portfolio Performance in 1991'), about 90 per cent of the variation of a fund's return over time can be explained by differences in asset allocation.
When investors determine their strategic asset allocation, the biggest mistake they can make is to adopt a strategy which poorly matches future needs and circumstances. A well-targeted strategic allocation best meets the requirement that investments carry an appropriate level of risk to cover future commitments. In contrast, an inappropriate asset allocation mix can leave investors exposed to too much risk, which can leave a greater chance of a serious shortfall in the future.
In the absence of a clearly defined rebalancing strategy to maintain this strategic asset allocation, the actual allocation will drift and is left unmanaged. This introduces unnecessary and unrewarded risk. It is, however, important to remember that there is no single asset class or allocation strategy which can guarantee both opportunities for high returns as well as safety in the short term.
Rebalancing - what is it?
There is no denying that volatility in today's markets is incredibly high. All stocks, whether they are value stocks, growth stocks, large caps or small caps, have fluctuated dramatically on the back of the global turmoil. The fact that different assets have performed differently means they now constitute different percentages of the value in a portfolio. The strategic asset allocation and actual portfolio have diverged, and the need to rebalance or make adjustments to the portfolio back to its original balance arises.
Passive rebalancing = passive market timing
While every investor wishes to buy low and sell high, in reality, research has shown that consistently trying to time the market in this manner is very challenging.
In the absence of strong tactical market views, rebalancing provides a solution through passive market timing. The process essentially forces a partial sale of asset classes which have recently outperformed, to transfer the proceeds into asset classes which have performed less well.
Rebalancing naturally encourages the selling of expensive assets and the purchase of cheaper ones. This is essentially a 'buy low, sell high' strategy.
However, rebalancing will not systematically add or detract value but it keeps a portfolio close to the desired mix which is based on their risk tolerance and return expectations.
An asset class that has significantly outperformed can create another set of problems. Holding on to winners may be very tempting, but it can chip away at a portfolio's diversification over time.


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A case in point
Up to the third quarter of 2007, we saw a sustained bull run in global equities. In that period, investors who did not rebalance benefited from the market rise, but became significantly over-exposed to equities.
Without rebalancing and assuming no cash flows, a sample portfolio that allocated 70 per cent to global equities and 30 per cent to global bonds in 2003, would have seen a 79 per cent global equities exposure by 2007, with only 21 per cent in global bonds.
Up to this point, investors who did restore their funds to their target allocation by rebalancing, for example by selling equities to purchase bonds to correct the imbalance, were not participating as fully in the bull market and their returns lagged.
But the initial feelings of regret turned to relief for investors who rebalanced as shares went into a tailspin after the bubble peaked in October 2007. In the space of months, equity prices plummeted. Those who restored their asset allocations to strategic targets managed to lock in profit. Those who went with the flow and did not rebalance, in contrast, suffered greater losses and a great deal of regret, in some cases.
Should you still rebalance in the current financial environment?
Dramatic and ongoing declines in the equity markets across the globe have caused some of our clients to question whether adhering to their strategic portfolios and rebalancing rules still makes sense. We advocate sticking to strategic targets and continuing to follow rebalancing rules as long as it is feasible. Investment principles and historical lessons support this approach; it is during periods of market stress and uncertainty that these policies become particularly important. To have any chance of recovering lost asset value, you need to be fully exposed to the market when it recovers. And we will, in all likelihood, only know when the market has recovered after the fact.
Lessons from the past
History provides us with a variety of examples of how large stock market moves can result in actual allocations that are widely different from an investor's desired allocation - unless they take corrective action by rebalancing.
For example, for a portfolio with a strategic asset allocation of 70 per cent equities/30 per cent bonds, the 2000-2002 equity falls would have changed that allocation to 57 per cent equities/43 per cent bonds. The impact of the 1929-1932 equity bear would have been even more pronounced, reversing the equity/bond weighting to 45 per cent/55 per cent.
As a result, the overall risk profile of that portfolio would have shifted to a much more defensive bias. Consequently, in the years that followed, the portfolio would have missed out on much of the resulting equity upswings which were 105 per cent and 187 per cent respectively, compared to gains for bonds of only around 20 per cent. A big underweight position to moves of that magnitude represents a significant opportunity cost in the context of the risk tolerance agreed by investors at the outset, with commensurate potential shortfalls in funding.
The same principle applies to rebalancing during equity bull runs. During the equity bull market of 1993-1999 which culminated in the tech bubble, it appeared to some market participants that we had entered a permanent new era of technology-driven growth. An investor who failed to rebalance would have found his 70/30 equity/bond mix shifting to 81 per cent equities/19 per cent bonds, representing a much more aggressive strategy.
In the ensuing bust, equities fell by 42 per cent whilst bonds rallied strongly by 34 per cent. A consistent application of a rebalancing policy would have left an investor's portfolio much better placed for the bust, in line with their pre-determined strategy.

 

[besotted]

That's what I always tell her

Make sure both are balanced - so sometimes must massage the left breast and sometimes the right