The portfolio balancing act
With summer approaching, I recently decided to dust off my bicycle and regain my former fitness levels. My body, however, made it clear that age moves faster than my bicycle can move up Suikerbossie, so once I got home, I ran the deepest Deep Heat bath possible. Upon getting in with heavy legs, I discovered that the water level had risen enough to cause the biggest tsunami Cape Town has ever seen if I dared to sit down. I got out, pulled the plug and waited anxiously for the water level to drop, only to realise that my belly protruded from the water once I finally got to lie back and relax. So yet again, I opened the taps and realised that I had just found the best way to explain the rebalancing of investment portfolios.
The primary objective of rebalancing your portfolio is to reduce risk through targeted asset al location, and not necessarily to increase your returns. Various asset classes move in different ways (much the same way as my bathwater), which means that asset allocations within a portfolio automatically change over time as each class moves individually. This encouraged me to determine the best way to rebalance portfolios, as rebalancing doesn’t come cheap.
Why? First of all, any sale in your portfolio will trigger a tax implication (short-term trading will trigger income tax, while long-term trading will trigger capital gains tax). Secondly, there will always be transaction costs involved, whether you are buying or selling. THREE WAYS TO BALANCE YOUR PORTFOLIO
Time method Based on time, you will rebalance your portfolio at a predetermined time. Let’s suggest that your initial investment comprised a 60% allocation to local shares and 40% to local bonds. Should you choose this method, you may decide to restore your intial 60/40 allocation on a monthly, quarterly or annual basis.
Threshold method The threshold method provides an investor with a bit more freedom as it often means you have to rebalance less frequently. By using this method, you will only rebalance once your allocation exceeds a set threshold. By using the previous example and applying a 10% threshold, you will only restore your portfolio to the initial 60/40 allocation if your weight in shares grows to more than 70%.
Combination Alternatively, i nvestors may apply a combination of these methods by monitoring weights at a predetermined time (monthly, quarterly or annually), but only rebalancing if the set threshold is exceeded.
In researching these methods, I tried to determine whether regular rebalancing actually benefits your investment. In short, not really (see table).
By running data for the past 20 years, we found that if you had compiled a portfolio consisting of 60% shares and 40% bonds and made no changes since, your annual returns, excluding costs, would amount to 15.7% with an annual volatility ratio of 11.7%. Had you rebalanced this portfolio on a monthly basis to restore your intial 60/40 ratio, your returns would have dropped to 14.9% (excluding all rebalancing costs and taxes), with a somewhat higher volatility ratio of 12% a year. Applying quarterly and annual rebalancing didn’t make much of a difference to these totals, nor did the combined time and threshold level (10%) method, which left us with returns (after costs and taxes) very close to those yielded by the passive approach.
My message to you this week is that although asset allocation remains extremely important in the management of your portfolio within your risk profile, you should guard against switching between different asset classes too often. Make sure that this will add true value to your portfolio so that you don’t have to keep emptying and f illing up your bathtub to find the perfect water level.