The right way to rebalance your investment portfolio

Portfolio rebalancing plays an important role in the management of diversified investment portfolios. Its primary function is to keep portfolio risk in alignment with an investor's risk tolerance and goals. Absent of portfolio rebalancing, portfolio allocations can drift from their intended target and this may lead to unanticipated outcomes. These outcomes could mean forgoing returns because your equity allocation drifted lower in advance of an equity market rally, or conversely, experiencing more volatility than expected in your portfolio if your bonds were underweight in advance of a sharp sell-off.

During periods of heightened market volatility, such as the 2008 Global Financial Crisis or last year's COVID sell-off, any misalignment of asset allocation with the intended investment strategy can show up in the form of deviations in risk and return, potentially jeopardising investor goals.

It doesn't require much of an imagination to picture a retiree's reaction to the 2020 COVID equity market correction particularly if the portfolio was overweight in equities. But even more damaging is the potential for rash decisions following such an event, and selling out of the initial investment strategy. This is often the result of an investor taking on more risk than they can tolerate and then, selling out of their strategy at the worst possible time.

During the COVID sell-off, the importance of holding a well-diversified, regularly rebalanced portfolio, was underscored amongst Vanguard's global investor base. We observed very few Vanguard investors losing their nerve, despite experiencing equity market falls in excess of 30%. Published Vanguard research into the behaviour of our US-based investors demonstrated that less than 0.5% of self-directed clients panicked by moving their portfolio to cash during this period. The research shows that of those who moved to cash, more than 80% would have been better off staying the course.

There are a few ways that investors can rebalance their portfolio, and the good news is that a straightforward disciplined rule can be almost as effective as the more complex methods available.

Straightforward rebalancing rules can comprise either a "calendar" or "threshold" rule. A calendar rule simply means that a set period is established on a quarterly, semi-annual or annual basis during which your asset allocation is rebalanced back to your portfolio target. A threshold rule is one where you actively monitor your allocations and rebalance back when your asset allocation is a certain distance away from your target, such as a range of +/-5%. A combination of the two whereby positions are monitored quarterly, but trading only occurs if a threshold is breached is an effective way to combine the two, and minimise the trading costs that could result from rebalancing too frequently.

Vanguard research has found that for portfolios supporting long term goals, the exact time and threshold limits you decide upon are less important than the discipline of adhering to a consistent approach. Striking a balance that keeps your portfolio broadly aligned with your target asset allocation, while ensuring you aren't trading too frequently and racking up costs, will see you well placed to achieve your goal.

Investors who don't have the time or energy to employ a disciplined rebalancing approach could avail themselves of diversified portfolios or strategies that undertake regular rebalancing on their behalf.

One of the resulting benefits of having rebalancing being done on your behalf is the ability to avoid the behavioural challenges that come with rebalancing your own portfolio. During a period of equity market volatility, selling bonds and buying equities can be an emotionally fraught decision for even the most informed investors, particularly when the general sentiment is tilting towards doom and gloom.

As our research has shown, the majority of investors who undertake a rebalance at such times are better off in the long run than the small proportion that forsake their strategy and move to the purported safe harbour of cash.

Ultimately, investors should make sure their equity allocation is in line with risk tolerance, that there is adequate diversification across asset classes, and ultimately that they adhere to a portfolio rebalancing strategy that allows them to stay on track to achieve their investment goals.

Aidan Geysen
14 Sep, 2021

vanguard.com.au