A Careful Balancing Act

I read an excellent column in last week’s FT which addressed the issue of portfolio rebalancing. This might sound a somewhat tiresome and technical subject but it is actually one of the fundamental elements of effective and disciplined portfolio management.

The key point about portfolio rebalancing is to ensure that the spread and percentage of asset classes in a portfolio are kept within a given proportion – and why is that important? The answer comes down to the level of risk that investors are willing to accept. In Vanguard’s recent research paper they cite data from 1926 to the present covering the US equity and bond markets. What their figures illustrate is that if you had a portfolio with a split of 60/40 with just equities and bonds, then if there was no rebalancing discipline during that time there would have been an equity creep such that you would have ended up with 97% in equities. This ‘equity creep’ occurs as equities should rise in value over time.  As a result this would now have become a very high risk portfolio – for a client who probably would have signed up for something a lot less risky.

Thus by having a discipline of controlling the pressure of rising equities, the risk levels can be maintained and controlled. This then gives rise to the subsequent questions of how often to rebalance and at what trigger of percentage variation would be appropriate. 

So what to do? Well some do nothing at all – in which case you are left with that tiresome equity creep. Or alternatively, rebalance to exact percentages on an annual basis.

Does it work? Yes.