As seasons change, the temperature can fluctuate dramatically. Maintaining a comfortable temperature inside your home requires your thermostat to balance heating and cooling. The thermostat doesn’t have opinions on the weather; rather, its role is to adjust to a comfortable target temperature. Building a balanced, well-diversified portfolio is similar. Setting a desired goal for investments and maintaining balance over time requires adjustments.
Once investment goals have been set, a portfolio can be constructed toward achieving those goals. A well-diversified portfolio typically holds multiple asset classes such as stocks, bonds, alternative assets, and cash. Each asset class plays a specific role in helping the portfolio reach its objectives. The distribution across asset classes is referred to as asset allocation, with the mix for each investor set based on desired risk and return characteristics. Developing and maintaining the appropriate asset allocation is critical to making sure assets align with an investor’s risk profile and goals.
A common occurrence that investors may encounter is deviation from established asset allocation targets. This article examines this phenomenon, which is commonly known as allocation drift. Calculated and timely actions are needed to maintain the right asset allocation mix.
What Is Allocation Drift & What Causes It?
Allocation drift occurs when a portfolio deviates from the investor’s established asset allocation targets. If not addressed, the investor may be exposed to more risk than is appropriate or might have less growth potential than is required to achieve their investment goals.
For example, a common balanced portfolio reference is 60% invested in stocks and 40% to bonds. Because stocks and bonds can produce materially different returns over time, this allocation can change. For example, if stock returns are substantially higher than bond returns for a period of time, the allocation could reach 80% stocks and 20% bonds. This new allocation would increase risk beyond what is appropriate and intended. For the balanced investor, this higher-risk portfolio would produce unwanted results in the event of a meaningful stock market decline.
How Does One Address Allocation Drift?
When a portfolio drifts from its target allocation, repositioning from the asset classes that have experienced more rapid appreciation toward those that have appreciated less will bring the portfolio back in line. This action is called rebalancing. The two most common approaches to rebalancing are based on frequency and allocation thresholds.
Frequencies
Calendar-based rebalancing uses set frequencies of time for reviewing and rebalancing the portfolio. For example, reviews could occur quarterly, semiannually, or annually. The simplicity of having a set review cycle makes it easy to implement. However, this approach can be susceptible to rebalancing at an inopportune time or missing interim opportunities for rebalancing. Rebalancing more frequently than quarterly is typically not recommended, as trading may become excessive.
Thresholds
Threshold-based rebalancing uses established ranges around each asset class target to trigger rebalancing. When the allocation drifts outside of the acceptable range, rebalancing occurs to bring the portfolio back to target. Setting proper ranges is crucial. If the range is too narrow, rebalancing will occur too often. If the range is too wide, the portfolio may not be rebalanced often enough. Using the simple 60% stock and 40% bond example, a 5% threshold could be established. This would allow stocks to fluctuate between 55% to 65% while bonds could fluctuate from 35% to 45%. When the allocations are within these ranges, no rebalancing occurs. When asset classes move outside of these ranges, the portfolio would be rebalanced back to the original targets. This framework requires ongoing monitoring to detect times when the portfolio exceeds the thresholds.
Other Considerations
Rebalancing is a relatively simple and effective process, but there are things to keep in mind to help avoid unexpected consequences. Rebalancing requires selling higher-performing securities to purchase lower-performing securities. Those higher-performing securities likely have embedded capital gains that would be realized by selling. Realizing gains is a natural part of investing and should not be viewed negatively. Rather, it is a consequence of an investment generating a positive return. Setting an annual capital gains budget can help address this aspect of maintaining and rebalancing an investment portfolio. However, each investor should consult with their tax advisor annually to consider the specifics of their tax situation.
Setting a comfortable “temperature” for your portfolio and maintaining it throughout changing investment seasons is important. A key part of portfolio discipline is regularly rebalancing to the target allocation. Not only does this naturally result in “selling high” and “buying low,” but it also keeps the portfolio risk profile consistent throughout market cycles. This process helps investors avoid emotional decision making, which should lead to improved long-term investment results.
How Forvis Mazars Can Help
After multiple years of above-average stock returns, many investment portfolios may be out of alignment with goals and objectives. Now is a great time to review for possible rebalancing opportunities. If you have questions or need assistance with your investment portfolio, please reach out to a professional with Forvis Mazars Private Client.
Forvis Mazars Private Client services may include investment advisory services provided by Forvis Mazars Wealth Advisors, LLC, an SEC-registered investment adviser, and/or accounting, tax, and related solutions provided by Forvis Mazars, LLP. The information contained herein should not be considered investment advice to you, nor an offer to buy or sell any securities or financial instruments. The services, or investment strategies mentioned herein, may not be available to, or suitable, for you. Consult a financial advisor or tax professional before implementing any investment, tax or other strategy mentioned herein. The information herein is believed to be accurate as of the time it is presented and it may become inaccurate or outdated with the passage of time. Past performance does not guarantee future performance. All investments may lose money.