The port­fo­lio bal­anc­ing act

Finweek English Edition - - MONEY - BY SCHALK LOUW Port­fo­lio man­ager at PSG Wealth

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.

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