What is rebalancing?
It’s the process of re-establishing your target asset allocation in a diversified portfolio based on your investment time horizon and risk profile. The allocation of your portfolio always drifts, as some of the investments will outperform the others, which is why you diversify. If your investment goals haven’t changed, your asset allocation shouldn’t either, but because of market forces, it does. So, every so often, you need to rebalance your portfolio to restore its original allocation.
Rebalancing is primarily about risk control to ensure that your portfolio isn’t overly dependent on the success or failure of one asset class or investment style. No one investment class or style stays in favour continuously. Nobody, not even the smartest investment analysts, know what asset class, sector, unit trust or investing style is going to win next year, or how quickly things may change. Trimming back on a winner locks in your gains and positions you to benefit from the changes in market cycles.
Without rebalancing, you may end up taking on too much risk, which is all very well in a bull market but a recipe for disaster when the markets turn. Think back on some of the supposed past darlings of the stock market, such as Steinhoff. Trimming back on some of your profits along the way and rebalancing your portfolio would have provided some protection from the unexpected downfall. Similarly, if your portfolio becomes too conservative, it’s likely that you won’t achieve your important long-term objectives, such as saving for retirement.
It’s advisable to rebalance your portfolio at least annually. However, we have studied South African asset class total returns that show that by rebalancing a diversified portfolio (60% equity, 30% bonds, 10% cash) on a quarterly basis, you can reduce the volatility in the portfolio by about 3%. This can be significant if your investment horizon is relatively short and you can’t afford much risk.
You can also rebalance when making additional contributions to, or withdrawals from, your investments. If you have additional funds to invest, you could buy more of the investments that have diverged negatively from the original allocation. If you need to withdraw funds, simply sell some of the investments that have diverged positively from the ideal.
What about the downsides?
The very thought of paying capital gains tax (CGT) when you sell a portion of your portfolio is sometimes enough to put investors off the rational need for changes in asset allocation.
Thankfully, only 40% of the gain is added to your income, and you can benefit from the R40000 annual exemption.
It’s beneficial to use the exemption every year even if rebalancing means selling and buying back the same stock. Buying and selling resets your base cost at a higher level, which will reduce future CGT. The good old adage that nothing is certain in life except death and taxes is very relevant here in that CGT always applies, because when you pass away, there’s a deemed sale of your investments.
Some investors also fear transaction fees, but most professional advisers do not charge for rebalancing a portfolio of unit trust, because it makes no sense to penalise clients for following a sound investment philosophy. Costs can be more significant if you have a share portfolio, so be sure to get sound advice.
Strength of a balanced team
It’s understandable that investors don’t feel inclined to cut the legs from a winner when the market is bullish. But the tide always changes, and optimal diversification between asset classes always trumps.
Rebalancing is a methodical way of ensuring that your strategic asset allocation is true to your goals. Think of it this way: many minds - or many different asset classes - make good decisions. A balanced-team approach always wins.
Janet Hugo is a director of Sterling Private Wealth and the 2018/19 Financial Planner of the Year.