From the July 2004 issue of Investment Advisor • Subscribe!

July 1, 2004

TOOLS OF THE TRADE- Rebalancing Act

The issue of rebalancing clients' portfolios is faced by all investment advisors. Most of you would agree that rebalancing can have a tremendous impact on clients' investment returns. But rebalancing is not an easy task. Moreover, if employed for the wrong reasons, it can seriously damage your clients' financial health.

You therefore must constantly decide not only if you should rebalance a client's portfolio, but also when, why, and how often. The big question to ask is what you hope to accomplish by rebalancing. The following guidelines can help you make optimal rebalancing choices and deliver truly successful investment experiences to your clients.

Rebalancing, or Market Timing?

Let's begin by examining one of the most common mistakes that advisors make when rebalancing: Using economic forecasts to guide their decisions. A forecasting approach, of course, encourages you to make changes to clients' asset allocation based on someone's predictions about the year ahead. If 50 economists expect robust economic growth, for example, you'd respond by boosting your clients' exposure to equities.

If you're familiar with my past columns, you know how much value I place on predictions: Zero. That includes my own forecasts. When asked what the markets will do over the next few months, I always have an opinion--but I learned long ago not to base investment decisions on them. The future is unknown and our current opinion can only reflect what we already know. What's more, the "market" reflects that knowledge. So you have to make a guess about whether there will be more good news than bad (or vice-versa) in the coming months. Rebalancing is far too important to be left to guesswork. What's more, we all too often get it wrong. Why would you make major decisions about your clients' asset allocation using methods that intrinsically carry an enormous degree of uncertainty?

I firmly believe that if your efforts are based on guesses about the future, even if those guesses are educated ones, you are not rebalancing at all but are trying to time the markets. Of course, there's plenty of data documenting the failure of market timing as a legitimate investment strategy. One you can share with any doubting client comes from a 1998 issue of Business Week that Larry Swedroe cites in his book, Rational Investing in Irrational Times (St. Martin's Press, 2002). In the article, Mark Hulbert, publisher of Hulbert's Financial Digest, examined the performance of 32 market timing newsletters during the 10 years through 1997. Remember, this was a period that saw the S&P 500 gain 18% annually. The typical timer's return, by contrast, was 11.1%. Worse, not one of the newsletter portfolios beat the market: The average annual returns ranged from 5.8% to 16.9%.

If your clients realize that you are using rebalancing to time markets, be prepared to spend a lot of effort seeking new clients each year. All but the most naive investors understand the risk of trying to time markets accurately, and you will be held accountable if you happen to get it wrong.

Of course, Wall Street has made sure market timers don't have to label themselves as such. Instead, they've invented a very impressive-sounding term--tactical asset allocation--that enables you to play the market timing game without telling the client it's the same old game. I cannot view tactical asset allocation as anything but market timing. After all, it makes changes to the portfolio asset mix based on somebody's guess about the future direction of the market. Favorable forecast? The tactical approach says to increase equity exposure. Unfavorable? Emphasize bonds. If that's not market timing, I don't know what is.

If we know that tactical asset allocation is just another form of market timing--and it is--and if we know that market timing doesn't work--and we do--then the obvious question must be asked: Why does tactical asset allocation persist?

For some advisors, it's merely a way to generate transactions that help line their own pockets. But I do not believe that applies to the vast majority of advisors who use this approach. Instead, advisors using tactical asset allocation truly believe it is their duty to "take action" in order to add value by moving clients' money around from one "opportunity" to the next. It's also appealing because it doesn't force you to make hugely bold calls, such as going to 100% stocks or 100% bonds. Instead, the tactical playbook lets you "tweak" your clients' allocation so you don't really have to put yourself "out there," so to speak.

But you don't have to make huge bets to damage your clients' returns (not to mention your relationships with your clients). Even small adjustments can hurt when markets move significantly in ways you don't anticipate. For example, you may be facing pressure from clients to over- and underweight asset classes based on current events and future forecasts. Some of your clients are no doubt worried about Iraq, oil prices, and other developments, and have asked you to lighten up on equities for the time being.

Let's say you give in. You may feel great in the short run. After all, the clients think you're terrific because you've listened to them and made them happy. But if the market moves up because there is more good news than bad, that tactical decision will cost your clients a great deal of money. Moreover, clients are not going to remember that they were the ones who talked you into trimming their equity exposure. They will remember to blame you for not helping them stay the course. And they should blame you: You've become a facilitator, not an advisor.

A Better Approach

So how should we approach rebalancing? Well, it depends. In some cases it's quite clear that a client's current asset allocation must be changed, while in other instances it's best to buck conventional wisdom and do nothing. Consider the following three scenarios:

Changes in the Investor Profile. The investor profile that you develop for each new client is the single best tool for instituting your rebalancing policy. That's because the initial asset allocation you design for the client flows directly from the information contained in the profile--age, health, income, number of dependents, net worth, goals, risk tolerance, and so on. Once you have an allocation that accurately reflects all aspects of the client as a person and an investor, the best reason to consider altering it is if that profile changes meaningfully. It might be something as simple as the investor getting older, or as unexpected as a huge inheritance or, God forbid, the loss of a high-paying position. When a significant development occurs, it's the right time to ask, "Has my client's investor profile changed enough to justify a change in the asset allocation?"

The answer could be "No." Say a client loses his job. If he's young with strong prospects for getting a new, comparable job quickly, you might do nothing. However, you're more likely to make changes if a 55-year-old client is let go. The conclusion: While new developments in the profile are the right moments to reexamine the asset allocation, they're not always the right times to take action. It's up to you and your client, working together, to find the answer.

Developments in the Capital Markets. Our understanding of the capital markets is always progressing. As I like to say, the "final chapter" of financial economics will never be written. For example, research may reveal that a group of securities possesses risk and return characteristics that would indicate the presence of a separate asset class. This knowledge will cause the asset class to be made available to investors, and gives you an appropriate moment to review your clients' asset allocation with an eye toward rebalancing. Because of REITs, for example, we now have the securitization of the real estate market. If you believe that real estate is a separate asset class with unique risk/return characteristics, you may decide it deserves inclusion in your clients' portfolios--thereby requiring rebalancing activity.

Price Movements of Asset Classes. Many advisors favor a strategic approach that calls for automatically rebalancing back to a target asset mix every quarter or whenever asset class weightings go beyond a certain range, such as +/-5 percentage points. That's the approach I took when I was an advisor.

However, I discovered that this process can be too simplistic. The trouble with regularly selling winners and buying losers is that you risk generating hefty tax bills for your clients. Therefore, big swings in the performance of asset classes must be dealt with on a case-by-case basis and reflect the true needs of each particular client. Whereas one might be most concerned about risk management and require regular rebalancing, another may have potential tax liabilities that outweigh the benefits of frequent strategic rebalancing.

That said, there is one approach to strategic rebalancing that always makes sense. To avoid generating taxable gains, use new money that clients bring to you. Advisors often overlook this strategy, yet it's extremely effective and can be quite easy. At a conference a few years back where I was discussing rebalancing, an advisor stood up and said, "Whenever I need to rebalance I just pick up the phone and say 'Send me more money!'" He got a chuckle from the other advisors in attendance but a lot of them took note.

That might be a bit too forward for some of you--but your clients do expect you to take charge of their financial situation. They have other things on their minds and will be more likely to send more money your way as their confidence in you grows. Here again, we see that the rebalancing process is yet another opportunity for you to sit down with clients, review their needs, and show the value you bring to them every day.

Remember, if you do your job, the numbers will take care of themselves.

Dan Wheeler is director of global financial advisor services at Dimensional Fund Advisors in Santa Monica, California. He can be reached at dan.wheeler@dfafunds.com.

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