Rebalancing

Rebalance, rebalance, rebalance – how often have you heard this from your advisor? Likely pretty often (if not, maybe it is time to consider a second opinion with the James Financial Advisory Group), but what exactly does it mean? And what does it look like in practice?

Asset allocation is not a one-step process. Your overall asset mix should be periodically reviewed and rebalanced. For example, your equity allocation may underperform your fixed income allocation. When this occurs, rebalancing will trim from the best performing asset class and add to the underperforming asset class. This is not restricted to certain asset classes, it may occur within asset classes (i.e. trimming a stock position, rebalancing among growth and value stocks), and among specific geographic regions. Below is an income and growth portfolio with a 50/50 equity and fixed income asset mix. Suppose the equity market went down by 30% and fixed income went up by 5%:

Let’s look at it in terms of dollar value. If you started with $1,000,000 which was invested equally between fixed income and equities, and the equity market dropped 30% and fixed income went up by 5%, your $500,000 in equities is now worth $350,000 ($500,000 less 30%) and your fixed income is now worth $525,000 ($500,000 plus 5%). Your total portfolio is now worth $875,000 with a fixed income allocation of 60%, and equity of 40%.

Let’s compare two different scenarios: (1) Leaving the portfolio as is, (2) Rebalancing back to your target asset mix after equities lost 30% and fixed income gained 5%. After this rebalance, let’s suppose the equity markets bounce back by 35% and fixed income is down by 5%. The rebalanced portfolio will have outperformed the portfolio that was not rebalanced by $35,000 or by 4%.

This is an extreme example…it’s impossible to find the “bottom” of the downturn. However, we WISH WE COULD!!! But you don’t need to find the bottom for this strategy to be effective. By rebalancing with cash flows and/or setting “triggers” for your portfolio, say 10% off your target asset mix, your portfolio will rebalance. In a 20-30% downturn, this may result in a few rebalances, and that’s a good thing. This will create a defaulted “buy low and sell high” strategy, which creates the potential to both add incremental gains and reduce volatility.

If you would like to see the math, or have any other questions, please don’t hesitate to reach out to the James Financial Advisory Group and contact Lindsey Haines at 506-451-8878 or Lindsay Herron at 506-451-8872.