Rebalancing is one if the most under utilized and under appreciated aspects of investing. An active asset allocation strategy, which requires frequent rebalancing based on current opportunities and risk, is the most successful strategy in today’s investment environment.
The purpose of diversification is to reduce risk by holding investments that will behave differently at different times. Over time, as a portfolio’s assets change in price it can easily move the portfolio to a position that risk and return become inconsistent with an investor’s goals and risk preferences. As some assets increase they make up a larger percentage of the portfolio; at the same time, the declining assets become a smaller percentage. If an investor does not rebalance the portfolio it will gradually move to high return and higher risk investments.
Portfolio rebalancing forces you to buy low and sell high. For example, let’s say you have a target asset allocation of 10% for asset A and a target asset allocation of 10% for asset B. Then let’s assume asset A increases 50% and asset B declines by 50%. Now you own 3 times as much asset A compared to asset B because asset A has increased to 15% of the portfolio and asset B has declined to 5% of the portfolio. After these fluctuations, not only is your asset allocation out of balance, but now you own more of an asset that has just risen 50% and may be overvalued and own less of an asset that may be extremely undervalued. Rebalancing forces you to sell the overvalued asset and buy more of the undervalued asset.
An active asset allocation strategy allows an investor to take advantage of volatility by being more conservative when an asset price is high and more aggressive when an asset price is low. Take the above example; with asset A up 50% and asset B down 50% an investor may choose to move his target asset allocation to reflect the relative risk of each asset. Instead of rebalancing to 10% each, an investor may decide that asset A, because it is now overvalued should only be 7% of the portfolio, and asset B, because it is undervalued, should be 13% of the portfolio. If done correctly, the portfolio is still diversified but now has less risk and greater potential for appreciation at the same time.
Buy and hold strategies are producing horrible returns. Those who have followed this favored strategy have lost a whole decade of wealth building. Flexibility makes an active asset allocation strategy superior to a simple buy and hold strategy. There are two main differences between a buy and hold strategy and active asset allocation strategy. First, frequent or regular re-balancing is required; and second, an asset allocation decision must be made for each investment category based on the current opportunities and risk. This doesn’t mean the asset allocation must change, but an investor has the flexibility to change with changing conditions. The only drawback of an active asset allocation strategy is that it requires paying attention to your investment portfolio. Nothing good comes easy, but the reward can be much higher portfolio returns.
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