Risk & Rebalancing

When thinking about your portfolio it is easy to frame your investment decisions based on the potential return you may receive, but return is only part of the equation. Risk tolerance is as important if not more important than potential returns. When developing a plan for investment allocation, the first step should be reviewing your personal investment constraints. Examples of constraints can be cash-flow needs or your comfort level with volatility among other things.

For many investors, a mixture of cash, stocks, and bonds represent the largest portions of their portfolio allocations. Stocks tend to be the riskiest and most prone to volatility, and cash is typically the least risky. The percentage allocated to each of these three asset classes establishes your portfolio’s level of risk. People that have immediate cash needs or have worries about taking risk or experiencing market volatility may hold more cash and bonds than someone that is in pursuit of capital appreciation and has little worry about fluctuations in their portfolio value over time.

To ensure that an investor’s portfolio remains properly allocated, it is important to rebalance the stock-to-bond allocation at regular intervals. For example, if an investor decides that an appropriate allocation is 60% stocks, 35% bonds, and 5% cash, their portfolio is unlikely to stay here long-term. Stock and bond market fluctuations over time usually cause the allocation to drift, and this investor could see their portfolio allocation adjust to 66% stocks, 32% bonds, and 2% cash. In this case, rebalancing the portfolio would mean selling some stocks, buying some bonds, and leaving some extra cash in the portfolio. Along with resetting the portfolio’s investment allocation, rebalancing does a few other important things.

1.       Rebalancing can force investors to sell high and buy low. Naturally, through the process of rebalancing, investors will sell the asset classes that have grown the most and purchase investments that have not seen as strong of returns. It is important to remember that markets ebb and flow, and what is growing quickly today may be different than what will experience the most growth in the future.

2.       Rebalancing helps remove some of the emotional bias of buying and selling investments. Psychology plays a bigger role in investment decisions than most people recognize. The human brain wants to hold onto what is succeeding now, thinking that it may miss out on some of the growth in the future. While this could be the case, by not rebalancing investors can also open themselves to larger potential losses if growth does not continue.

3.       Rebalancing creates an opportunity to review the rest of your financial plan. For many investors, investments play a central role in their financial lives. Unfortunately, some other factors do not get the attention they deserve. Budgeting, insurance, estate planning and many other pieces of financial planning play an important role in creating a secure financial future and need to be reviewed regularly.

In conclusion, portfolio rebalancing is an important part of investment planning for everyone. Investors as large as Warren Buffet and as small as someone who has recently made their first investment should develop an asset allocation appropriate for their situation and regularly rebalance to ensure they’re sticking to a plan. Although it is important for everybody to understand what rebalancing is and its importance, implementing a plan can be daunting. If you feel like you need help, reach out to a financial professional to help you create and execute your financial plan.

- Shane Fagan, CIMA®, Worley Erhart-Graves Financial Advisors