Rethinking your Investments: How to Rebalance your Portfolio in 2021
Updated: Jan 4, 2021
Investment management consultant MATTHEW FEARGRIEVE explains the rationale for rebalancing your personal investment portfolio in 2021, and considers how frequently you should do this.
As 2020 draws to a close, there are several market trends that are emerging as forerunners for the main dynamics that will characterise the markets and define investor sentiment for 2021, the principal two being vaccine- and Biden- related. The former because the prospect of bringing covid under control will be a powerful rallying force for global markets. The latter because of the stark dominance of Big Tech and how signally it sustained the S&P500 at ridiculous levels, even during the darkest days of the pandemic in early 2020, prompting market jitters over the prospect of Joe Biden tightening the regulatory framework on tech giants in a values-based approach to financial regulation (more on this in our blog here).
Recovery hopes were buoyed in Q4 with the UK being the first to approve and roll out a covid vaccine, prompting investors to pile into pharma and healthcare stocks, as well as real bargain propositions like airlines. There were plenty of investors questioning their exposure to US large-cap stocks following Biden's election victory in November. And earlier in the year, as the pandemic unfolded, lots of portfolios were turned over in order to shift them away from income-yielding stocks (with dividends on the floor) to other sectors that were trading at discounts or were positioned as being more covid-proof (like pharma, logistics and home entertainment).
Readers of this blog will remember our 2021 outlook for equities, gilts and bonds (here) in which we discussed some of the economic dynamics that drive the outlook for these instruments in the US, UK and Eurozone. That blog generated so many questions about portfolio rebalancing that we thought we should dedicate a piece to that subject. So here it is.
What is portfolio rebalancing?
Rebalancing is the process of realigning the weightings of a portfolio of assets. Rebalancing involves periodically buying or selling assets in a portfolio to maintain an original or desired level of asset allocation or risk. For example, say an original target asset allocation that conformed to the classic 60/40 split of 60% shares and 40% bonds.
We all know that mutual funds that invest in shares do better over time than funds that invest in bonds. And so, over time, the value of a hypothetical 60/40 investment portfolio that is represented by investments in shares will increase, in proportion to the performance over time of the underlying stocks.
We also know that shares are more risky investments than bonds. And so, just as the portfolio's exposure to shares increases, so does its risk of loss. Hence the need for rebalancing, which is achieved by buying or selling assets in order to bring the portfolio's overall allocation split and risk profile back to what it started out as being (60/40 equities versus bonds, in our example), principally by selling some of what has risen in value the most, and buying more of what has not done as well.
Guarding against this stealth increase in risk profile will obviously be important for older investors, who will prefer to invest more conservatively as they approach retirement age. And, in this sense, the ultimate objective of rebalancing will be to ensure that the portfolio is at its most conservative at the time the investor prepares to draw out the funds to supply retirement income.
How often should rebalancing be carried out?
There are three possible approaches for the retail investor.
1. Rebalancing at fixed times throughout the year. This could be monthly, quarterly, or once or twice a year.
2. Rebalancing when certain divergence thresholds are reached: This approach clearly entails more vigilance and work for the investor, but has the benefit of limiting the portfolio's tendency to move out of kilter, like many (most?) did in the pandemic market volatility of Q2.
3. The third option is a mix of the two: reviewing at set times in the year, but only making changes if the allocations have reached a certain threshold, like 5% away from where they should be.
We prefer monthly and quarterly assessments, because weekly rebalancing would be overly burdensome, whilst a yearly approach would allow for too much intra-year portfolio drift. A major advantage of calendar rebalancing over more responsive methods is that it is significantly less time consuming and costly for the retail investor since it involves fewer trades and at pre-determined dates. The downside, however, is that it does not allow for rebalancing at other dates even if the market moves significantly, like it did in 2020. But then, more dealing incurs more transactional costs, and the average retail investor will have a limited appetite for the kind of time and financial investment that proactive rebalancing entails.
For the majority of retail investors with a basic stocks and bonds portfolio, reviewing just once or twice a year, and rebalancing at 5% thresholds, should be sufficient to guard against material portfolio allocation and risk drift.
Rebalancing for Asset and Risk Diversification
Market fluctuations over time will inevitably shape your portfolio's exposure to certain sectors and asset classes, resulting in imbalances. For example, should the value of stock X increase by 25% while stock Y only gained 5%, a larger proportion of the portfolio's overall value will be represented by the corporate issuer of stock X. Should the fortunes of that corporate entity take a sudden downturn, your portfolio will suffer proportionately higher overall losses.
Rebalancing is an opportunity for you to take some of the gains achieved by stock X and invest them in other stocks. By having funds spread out across multiple stocks, a downturn in one issuer or sector will be partially offset by the stability or upturns of the others, which can provide a reasonable level of portfolio stability.
So what should a retail investor do?
For the majority of retail investors with a basic stocks and bonds portfolio, reviewing just once or twice a year, and rebalancing at 5% thresholds, should be sufficient to guard against portfolio allocation and risk drift. The market turmoil of 2020 has been a lesson in rebalancing for many of us!
MATTHEW FEARGRIEVE is an investment management consultant. You can read more of his blogs here and see his Twitter feed here.