Rebalancing Act

By Sherrill St. Germain

Q: What is rebalancing and why is it necessary?

A: Rebalancing is the process of reviewing your portfolio on a regular basis to make sure that, over time, it continues to suit your financial goals, risk tolerance, and risk capacity.  Chances are it will involve selling certain assets, often those that are doing well, and buying others, probably those currently not doing so great.  Because this feels counterintuitive, many investors are reluctant to rebalance.  But, much like the spring yard cleanup many of us tackle at this time of year, there are several reasons why rebalancing is important and necessary.

1) Environments evolve.

The Joneses next door take down a stand of pine trees, and suddenly your shade garden is in full sun.  The hostas and astilbes that used to thrive are no longer suited to the location, and begin to show signs of distress.  So it is with portfolios.  As your kids near college age or you near retirement, the growth-oriented asset mix that used to be just right now begins to feel uncomfortably volatile. Or maybe, after gaining some experience investing, you're comfortable with the idea of taking on more risk in hopes of generating a higher rate of return.   When this happens, it's time to rebalance.

2) Fast growers overpower.

With apologies to Mae West, when it comes to gardening and investing, too much of a good thing can be, well, not so wonderful.  For example, if my yard is any indication, the climate in southern New Hampshire must be extremely favorable for tiger lilies, Virginia roses, all kinds of mint, and lilies of the valley.  All are beautiful in their own right but, if left to their own devices, would take over the whole yard, detracting from the overall effect. 

Investments are much the same.  Depending on the particular economic climate, certain asset classes will tend to take off while others falter.  Later, roles may be reversed.  Further, some investments (stocks) are by their nature generally more fast-growing than others (bonds) over time.  As a result, even if your target asset mix remains right for you, your portfolio will tend to veer from it over time, with fast growers taking up more than their fair share of the landscape, probably resulting in more volatility than intended.  When this happens, it's time to rebalance.

3) Weeds take root.

Despite thoughtful landscape design, careful plant selection, and meticulous maintenance, weeds inevitably crop up.  Left unchecked, they seem to multiply exponentially.  The experienced gardener knows that, to minimize their impact, weeds must be eliminated ASAP.

A similar scenario awaits investors.  No matter how much effort is expended in up-front analysis and selection, occasionally an investment choice goes bad.  With mutual funds, it can be the result of a change in money managers, a company merger or acquisition, or unreasonable fee increases.  Often, a fund falls victim to its own popularity, leaving its manager unable to find worthy investments for all the money pouring into it.  If you're holding one of these investments, it can adversely affect your results.  When this happens, it's time to rebalance.   

So am I suggesting you should monitor your portfolio like a hawk, ready to swoop in and make changes at any time?  Definitely not!  Just as it can sometimes be challenging to tell whether new growth in the garden will turn out to be a weed or a gorgeous perennial, it's not always clear at a given time whether a particular shift, blip, or hiccup in your portfolio (or your investing temperament) merits any action.  Also, there may be transaction costs associated with rebalancing, so you don't want to overdo it.  My suggestion?  Aim to get your portfolio reviewed at least once a year to strike just the right balance.  And when you're done, don't be surprised if you get the urge to do some weeding…