Portfolio rebalancing

As we are nearing the halfway point of 2015, we have been in the process of rebalancing many of our client portfolios.  

The general focus of rebalancing is twofold: to maintain the appropriate risk profile on portfolios and to focus on the "buy low, sell high" fundamentals. While most investors focus on the price side of the "buy low, sell high" strategy, there is an important "buy low, sell high" income component to the strategy as well.

The first type of rebalancing is what we call "asset class" rebalancing and is generally focused on maintaining the risk profile for the portfolio.  For example, let's assume that we have a target allocation of 60 percent stocks and 40% bonds for a portfolio.   If the stock market has been strong for several years, the stocks may have increased to 65 percent of the portfolio and the bond holdings may have declined to 35 percent.  If we wanted to rebalance the asset classes to the portfolio targets, we would sell 5 percent of the stocks, take those proceeds and use them to add 5 percent to bonds.  We'd then be back to the target allocation objective of 60 percent stocks and 40 percent bonds. 

We have tolerance bands for various portfolio allocation targets, and we generally won't rebalance unless an asset class deviates meaningfully from the target allocation.  The reason we require a meaningful deviation is that normal market movements often correct the allocations.  For instance, stocks may have had some strong returns for a few months and might be slightly over-weighted. But six months later, bonds are back and the allocation is in line with its target. Thus, no trades were really needed. But, when we have multiple years of positive returns in stocks and bonds, as we have had over the last five, we do periodically need to rebalance if portfolios are outside of our tolerance bands.

The other type of rebalancing we do is within asset classes.  For example, within our stock and bond holdings, we have target weightings for each security.  Periodically, we may need to rebalance among holdings if securities are outside of our tolerance bands for a specific position. 

For example, we generally follow an equal weight strategy for our individual stock positions.  That basically means we want to have roughly the same dollar amount invested in each company.

Currently, some of our energy businesses may be down in price because of the decline in oil and commodity prices. Conversely, some of our consumer-focused companies (like food and beverage or retailers) may have had larger price gains as a result of the steady recovery in the economy.  If the difference between weightings is meaningful, then we generally rebalance.

Here's a simple example: Let's say we invested $10,000 in an energy company and $10,000 in a consumer products company three years ago. Today, the energy company is valued at $8,000 and the consumer products company is valued at $12,000. To rebalance back to an equal weight, we'd sell $2,000 of the consumer products company and add $2,000 to the energy company. This goes to the "buy low, sell high" strategy on prices.

Rebalancing among stock positions also helps us enhance our overall portfolio objective of increasing stock dividend income. Enhancing dividend income is an aspect of rebalancing that is often overlooked.

When we rebalance among positions, we are often taking investments that might have a lower current dividend yield (because of their higher price) and moving some of those gains to companies that have a higher current dividend yield (because of their lower price). For example, we might have $100 invested in a company paying a $2 dividend and we shift that $100 to a company paying a $3 dividend. 

By rebalancing, the bottom line is we are working the "buy low, sell high" strategy on both the price and the dividend income side of the portfolio.

In general, our objective with portfolios is to minimize transactions and any associated taxes.  Usually, doing nothing is the right thing to do if you have a solid investment.  But periodically, some rebalancing is required to maintain the risk profile and hopefully enhance investment returns for portfolios.