When volatility strikes, the thought of selling assets that have held up well to buy into areas of the market that have been pummeled can be unpleasant, to say the least. But the decision not to rebalance is one of the worst things your clients can do.
Why? Because asset allocation is the most important factor in determining an investor’s financial success over time, and rebalancing is required to keep that allocation in sync with their goals and risk tolerance. Clients with balanced portfolios who don’t rebalance after a market crash will have seen their exposure to equities decrease and their allocation to conservative fixed income investments rise accordingly. That under-allocation to equities will put them at a distinct performance disadvantage when the market eventually recovers.
Three Approaches to Rebalancing
1. Time interval
Research shows that the time interval a client chooses for rebalancing — quarterly, annually, etc.— doesn’t meaningfully affect their long-term return potential. Given the costs of rebalancing — which include taxes, transaction costs and the cost of an advisor’s time — choosing an annual or semi-annual timeframe may make sense. Be careful of triggering short-term capital gains tax for investments held less than a year and consider opportunities for tax loss harvesting.
With this approach, a portfolio is monitored continually and rebalanced any time its allocation drifts by a predetermined percentage (e.g., 5 percent). In volatile times, this could mean rebalancing frequently within a short time period, which could significantly increase fees.
A hybrid strategy marries the two approaches by calling for rebalancing at regular time intervals only when the allocation has drifted more than a specified percentage away from the target.
Adding new money to an under-represented asset class (possibly through dollar cost averaging) in order to regain the target allocation is one way to reduce or eliminate the cost of rebalancing. In addition, rebalancing by selling appreciated securities in tax-advantaged accounts, like IRAs and 401(k)s, can help reduce tax consequences. Any tax-loss harvesting would of course take place in taxable accounts.
Adjusting Targeted Allocations After a Crash
In discussing rebalancing with clients after a correction, it’s important to leave room for adjustments to their plan as needed. Clients falling prey to recency bias after the last bull market may have been overly optimistic about the amount of volatility they thought they could handle.