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Rebalancing Portfolios

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Each of our clients has an investment strategy based upon their individual life situation which is documented by an Investment Policy Statement updated annually. During the course of the year, the individual investments that they own as well as their asset classes perform differently. The result of this is that their portfolio gets out of line with their investment strategy over time. Because of this, as investment managers we have to rebalance the portfolio to bring it back into alignment with the strategy.

What Does Rebalance Mean?
Rebalancing is the process of buying and selling portions of your portfolio in order to set the weight of each investment and asset class back to its strategy weighting. In addition, if an investor’s investment strategy or tolerance for risk has changed, we use rebalancing to put the portfolio into alignment with the new strategy.

Why Rebalance?
The investments in a client’s portfolio will inevitably change due to changes in economic conditions, changes in the performance of the individual companies or fixed income securities, or changes in strategy. As a result, the percentage that is allocated to different investments or asset classes will change, moving away from the target percentages anticipated by the investment strategy.

This change will increase or decrease the risk in client portfolios, which is the proximate cause for our rebalancing activity.

Is It Buy-Low-Sell-High or Buy-High-Sell-Low?
Many investors like to put money into a company after it has had a significant move up in price believing that the trend will continue forever. Unfortunately, past performance is not always an indication of future performance. Also, many investors, hold onto last year’s big gainers and sell last year’s big losers when they should be taking profits in companies that have moved up significantly in price to fully-valued or over-valued levels, and putting the cash generated from the sales into the under-valued companies whose prices fell but who have great future prospects.

How Do We Rebalance?

The desired frequency of portfolio rebalancing depends on transaction costs, the current direction of the market and capital gain tax considerations.

No more frequently than once a year is the standard practice; however, it can certainly be longer if the market trend is strong. We prefer to rebalance portfolios when the market is either in a topping process or a bottoming process based upon the technical indicators we follow.

Additionally, as the equity portion of a portfolio grows in size relative to the fixed income portion, the rebalancing will realign the asset classes to their strategic targets. In this way, rebalancing within the portfolio’s equity holdings and between the portfolio’s asset classes, you are reducing the inherent risk of the portfolio.

We are in the process of rebalancing client portfolios right now. We see the stock market and bond market at all-time highs, the current economic conditions globally as week, and many sectors of the stock market and individual companies well above historic valuations.

Over the course of a few weeks, we selectively sell assets that have out-performed, either in whole or enough shares to bring them back to target weighting within portfolios, we generate some cash, then redeploy it in companies that are either undervalued or that have corrected in price. Our trigger to know when there is a topping process underway is based upon the technical indicators we follow.

If you look at the graph above, you will see that I have annotated it with red circles on the short term directional indicators that show we have gotten ahead of ourselves and moved to an overbought situation – all are near or above their upper thresholds that indicate either the market is set to go down or move sideways, both of which cure the overbought situation. The two indicators at the bottom are intermediate term indicators – I have not annotated them but you can see (if you get out your magnifying glass) the uppermost one has just started to roll over while the bottom one has not yet indicated a turn. This is a pretty typical situation for these sorts of indicators. By the time the intermediate term ones both roll over the short term ones will show that we are well into a pull back. I also drew in a red horizontal line showing how the market pushed up against resistance three times, clearly failing the first two, and it appears the third time is rolling over and could repeat the pattern of the previous two.

Conclusion
The rebalancing process is a standard part of risk management within portfolio management.

Booking gains through the sale of assets that have increased in value and purchasing assets that have fallen in value is a discipline that, when followed, allows investors to weather the ups and downs of the market and ultimately see their portfolios perform according to their stated objectives.

Buy-Low-Sell High is the only way to make money in investment management, and rebalancing is one of the tools we use to ensure we do just that.

Mark