Asset allocation has been proven to be the most important factor in determining investment returns, and Sequence Risk (created by the particular sequence in which portfolio returns are generated), has a big influence on portfolios from which money is being withdrawn, so it is particularly important to make sure that your portfolio has the right asset allocation in retirement.
When you first retire, you may start with a beautifully designed portfolio, but, the markets have ideas of their own, dragging your lovely portfolio through every muddy puddle they can find. So, from time to time, you’ll need to pick your portfolio up, clean it off and make it beautiful again.
That’s what rebalancing is about. It brings your portfolio back into line, making sure that you are taking the right amount of risk through time. If you don’t bring your portfolio back into alignment, then pretty quickly, the markets will make sure that your portfolio doesn’t bear much relation to the one that you originally designed.
So, now that we know why you need to rebalance, how do you actually go about doing it?
Essentially, the idea is to sell the things that you have too much of, and buy the things that you have too little of.
But when should you do it?
Your portfolio is constantly on the move, so you could theoretically rebalance your portfolio every day (if you own ETFs, you could rebalance every few minutes!). This would ensure that your portfolio is as close to your intended portfolio as possible, but you would incur all sorts of costs – transaction costs, tax, tax administration costs, and of course, the cost of your (or your adviser’s) time. Ideally, you need the best blend of low costs and accurate asset allocation.
Retirement portfolios present different problems to standard growth portfolios. If you are looking for capital growth over a period of more than five years, there are plenty of solutions out there which will make sure that your portfolio sticks to its risk mandate whilst pursuing your growth objective. But the number of solutions needed for retirement income seekers is much bigger – simply because of the different withdrawal percentages needed (an investor with a medium risk tolerance level who needs to withdraw 2% a year will need a different portfolio to an investor with the same risk level who needs 6% a year), and because those withdrawal percentages change.
There are two main approaches to rebalancing:
- the time-based approach, where you rebalance every year, half year or quarter.
- the rebalancing band approach, where you only rebalance if an asset class moves outside of pre-specified bands. In other words, you let the portfolio run until it drifts too far out of line, and then you bring that portion of the portfolio back into line.
The second approach should produce better results, but it needs someone to keep a very close eye on your portfolio, to see when it has drifted out of balance. As a result, the costs are likely to outweigh the benefits, until specific technology is designed to do this at very low cost. So, until that solution is invented, the time-based approach will be the best solution.
So, how often you should rebalance?
The most common time frame that people use is annual rebalancing. They go in once a year to clean up their portfolio. But how does this compare to other frequencies? As usual, our American academic friends have done the work for us.
What their research showed us probably wasn’t surprising, although I do wonder if I just think it wasn’t surprising with hindsight!
The longer you leave between rebalances, the more risk you are taking. After all, the longer that we let a portfolio run without rebalancing, the further the portfolio will be out of balance. Since shares usually have higher average returns than fixed interest stock, the longer a portfolio goes without rebalancing, the more tilted towards shares it will be. The increase in the allocation will mean that portfolios with less frequent rebalances will carry higher levels of risk compared to portfolios that are rebalanced more frequently.
Most of the time, this accidental increase in risk will result in the investor getting a better return. So, most of the time, infrequent rebalancers will ride their luck (without knowing it) and get away with it.
But what the US research also showed was that the less frequent the rebalance, the higher the standard deviation of the annualized return. Put it another way, the volatility was higher. In layman’s terms, the less often you rebalance your retirement portfolio, the more likely it is that you will run out of money before you die!
As an example, if a portfolio that is rebalanced every five years happened to have been rebalanced just before the 2008 Banking Crisis, it wouldn’t have been hit nearly as hard as one that had been rebalanced back in 2004. The portfolio that hadn’t been rebalanced in a while would have had a higher accidental allocation to shares, and would have taken it on the chin when the bottom fell out of the market.
Costs are important
The reason you need to rebalance is to make sure that you are taking the right level of risk. And, logically, the less risk you would like or can afford to take, the more you need to ensure that your portfolio is rebalanced. But you can’t ignore the cost of rebalancing. Some investment products have no dealing charges, and there are no tax costs (or tax admin costs) when you rebalance. But others have charges each time you buy or sell, a capital gains charge could apply, and you might have to pay someone to fill in a bit of your tax return when you rebalance.
What’s the Answer?
So, the frequency that you should rebalance will depend on the amount of risk you can afford, and the costs of rebalancing. The chances are that the ideal frequency will be different for you than they are for your neighbour. And when it’s complicated, the best solution, as usual, is to seek advice.
Philip Wise | email@example.com
Managing Director and Chartered Financial Planner