Why is Portfolio Rebalancing Important for Executives and How To Do It

Why is Portfolio Rebalancing Important for Executives and How To Do It:

We’ve all met people at social gatherings who love sharing their investing success. 

For most financial planners, a red flag often pops up as we listen to the stories of gut-feeling stock picks and the golden investment tidbit that slipped out at a cocktail party.

Usually, several questions creep up:

  1. What analysis did you use to make your decision?
  2. What made you stay invested and not capture your gains and rebalance?
  3. Can the investment decision-making you used at that time be repeated?

Whatever your investment philosophy, we will explain why it’s important to rebalance your portfolio and how to do it.

Why is portfolio rebalancing important for Executives?

In any given period, asset classes experience different performances.

Some asset classes will appreciate, and some will lose value leading to changes in your asset allocation which impacts your return and risk characteristics that were (should have been) set up in your personalized written investment policy. It’s essential to stay balanced in your portfolio, which means understanding your individual risk tolerance, investment goals and revisiting them periodically.

Rebalancing a portfolio aims to restore it to its original target allocation based on the first rule of investing: buying low and selling high. The process involves selling assets that have appreciated in value and purchasing those that have declined in value to bring the portfolio’s allocations back into alignment. Typically, this involves setting percentage bands and rebalancing the portfolio once asset levels exceed those predefined limits.

What are the benefits of rebalancing your portfolio?

Rebalancing is a critical discipline that can help reduce portfolio volatility. It’s important to remember that your original asset allocation was based on your personal risk and return preferences for the long term. Rebalancing helps you stay aligned with those priorities. It removes the recency bias of holding onto investments based on recent performance and uses a systemized process to drive investment decisions.

We’ve seen in the last few years several investors with inflated technology holdings who wish they rebalanced and captured some of the gains. Hindsight offers many missed wishes, but a disciplined process may have helped avoid timing the highs and lows of asset classes and sectors.

Unfortunately, most people who manage their investments don’t rebalance.

Why is Portfolio Rebalancing Important for Executives and How To Do It
Why is Portfolio Rebalancing Important for Executives and How To Do It

They feel intimidated by the process and don’t know where to begin.

Other reasons people struggle to rebalance their portfolio:

  • Reason #1: They don’t know the benefits of rebalancing
  • Reason #2: They are hesitant to sell assets that have performed well in the past
  • Reason #3: They’re too busy and don’t have the time
  • Reason #4: They have a fear of missing out on future gains

It’s important to recognize these obstacles and emotional biases and take steps to overcome them.

How to rebalance your portfolio:

Step 1: Determine your target asset allocation

Identify and create a framework for your investment goals. This will depend on what stage of life you’re in.

Have you just sold your business and want the investment proceeds to support your lifestyle in retirement?

Have you just received the coveted Vice President position and seeking long-term growth?

Are you focused on creating a legacy and want your children to inherit your investment portfolio?

Step 2: Assess your risk tolerance

Evaluate your risk tolerance by considering your age, income, investment experience, and personal circumstances. A risk tolerance questionnaire or consultation with a financial advisor can help determine your risk profile.

Risk tolerance is a grey area and cannot be solely determined by an online questionnaire produced by many of the robo-advisors. We like to consider three legs of a stool: your willingness to take risk, your capacity to take risk, and your investment goals.

Step 3: Determine your investment time horizon 

How long you want to invest your money will determine the asset classes you choose and how much you invest in each.

Step 4: Select asset classes

Choose the asset classes that align with your investment goals and risk tolerance. Combining the risk-return characteristics of multiple asset classes optimizes returns and lowers risk in the long term. Individual investors have a preference for investing in what they know at home. This home bias may feel less risky, but investors are losing out on approximately 40% of the stocks globally. Adding asset classes to a portfolio should be strategic, and if not highly correlated with the other investments, it provides an opportunity to reduce risk.

Step 5: Determine the target percentage for each asset class

Based on your investment goals, risk tolerance, and time horizon, determine the ideal percentage of each asset class in your portfolio.

For example, a young couple with a long-time horizon may have a higher risk tolerance and a higher percentage allocated to stocks versus bonds.

Adjust the target allocations periodically: Review your target allocations annually and make any necessary changes in your investment goals, risk tolerance, or market conditions.

Step 6: Assess your current portfolio and identify the necessary trades to reach your target allocation

How does your current portfolio compare to your target portfolio? What do you need to buy or sell to reach your target allocation? What are the costs and tax implications of implementing this?

Step 7: Execute trades and monitor your portfolio

Make the trades in your portfolio and continue monitoring your portfolio.

When should you rebalance your portfolio?

Here are three different methods for rebalancing:

A. Calendar rebalancing

This involves returning allocations to target weights on a periodic basis, such as quarterly or semi-annually. This can be an automated process and doesn’t require constant monitoring. The downside is that it doesn’t consider market conditions that may have caused the allocation to drift away.

B. Threshold-based rebalancing

this involves having thresholds or trigger points for rebalancing. For example, if you allocate 60% to equities, you could maintain a tolerance band of 55%-65%. If stocks move out of this range, it will trigger a rebalance.

C. Opportunistic rebalancing

This involves looking for opportunities during market fluctuations to make changes to investment portfolios. For example, when a particular asset class experiences a price drop due to market volatility, an investor could increase exposure by reallocating assets from other areas of the portfolio. This method requires investors to monitor the market and understand their long-term investment strategy to achieve greater returns potentially. 

It’s important to note that this should not be confused with short-term trading.

Whichever method you use, costs are involved each time you rebalance your strategy allocation, so it’s worth assessing the trade-off.

Here are some of the costs:

  1. Sacrificing potential future returns. It’s hard to sell your best performing holdings. Historically there is  a reversion to the mean and it wouldn’t be wise to assume this time would be any different.
  2. Transaction fees. There may be fees or commission involved for trading ETFs, mutual funds or stocks. Check with the custodian you use or your financial advisor. If your advisor gets paid on these commissions, this should be disclosed to you. That’s why we recommend working with a fee-only CERTIFIED FINANCIAL PLANNER who is required to avoid unnecessary fees and doesn’t receive any commissions. 
  3. Taxes: If you are rebalancing in a taxable account, it may trigger capital gains. Ideally we wouldn’t ever have to pay taxes, but it’s better to pay some taxes on gains now than experience a loss from holding onto the investments too long.

In conclusion, setting up periodic portfolio rebalancing is crucial for executives to achieve long-term investment success. By recognizing the benefits of rebalancing and committing to a disciplined investment strategy, you can increase your returns and reduce risk over time.

At Adviso Wealth, we can help you develop a customized investment plan incorporating regular portfolio rebalancing to ensure you stay on track to meet your financial goals. Contact us today to learn more about how we can help you achieve your financial objectives.