The Need to Rebalance

Since the portfolio’s overall asset allocation can determine over 90 percent of its returns, a plan should include a way to maintain the asset allocation that meets your client’s risk tolerance and financial objective.

December 20, 2007
by Karen Beardsley, CPA/PFS

The new field of behavioral finance attempts to use psychological theories with economics and finance to explain why people make irrational financial decisions. When the average return on all equity mutual funds is 10.4 percent and the average investor’s return is 3.7 percent, something is wrong. The average investor is getting about one-third of the total returns because he is buying and selling at the wrong time for the wrong reasons.

After more than 50 years of academic research, the Modern Portfolio Theory and the Efficient Markets Hypothesis show that the ability to pick stocks, or to time the market, has almost no impact on your portfolio’s returns. Instead, your portfolio’s overall asset allocation has by far the single greatest impact.

As financial advisors, you sometimes have the difficult task of educating your clients about ways to avoid making commoninvestment mistakes. Like your clients, financial advisors are bombarded daily with e-mails, junk mail and evennewspaper and Internet articles on buying the next hot stock. As personal advisors, you have clients who listen to the radio on the way to work and suddenly become stock gurus. They want to have all of their portfolios invested in international, real estate, commodities, hedge funds or whatever the hot topic was for the morning.

To overcome tendencies to make mistakes identified by behavioral finance, financial advisors need to follow the investment planning process. This involves knowing your client and establishing an investment plan you can both work with. A major part of the investment plan should involve a consistent, disciplined, process to achieve the client’s long-term goals.

Since it is the portfolio’s overall asset allocation that determines over 90 percent of the returns, the plan should include a way to maintain the asset allocation that meets the investor’s risk tolerance and financial objective.

When Should You Rebalance?

Rebalancing is simply an adjustment to a portfolio of its original target allocations. No matter what the market does, that portfolio that you so diligently designed for your client months or even years ago to match their risk tolerances and long-term goals, may no longer be in alignment. Perhaps the emerging markets have had stellar returns and the large cap funds have not done so well. This “style drift” results in the portfolio being more aggressive and riskier than you or your client intended.

At a minimum, rebalancing should be considered as part of the annual portfolio review. Some advisors review the portfolios quarterly. Rebalancing may create costs in the form of transaction fees and taxes, so it is not feasible to constantly rebalance. It should therefore be done only when new funds are available for investment or when the asset allocation has shifted significantly. What is defined as “significant” is a judgment call by the advisor.

Let’s assume that a client’s portfolio is designed to be 80 percent equities and 20 percent fixed income. At your annual review, you see that the allocation has shifted and the portfolio is now 85 percent equities and 15 percent fixed income. Should you rebalance? This is where your role as the advisor becomes valuable. The sample portfolio is indeed out of balance. Before you decide to arbitrarily rebalance, you should consider some additional factors. Is this a taxable account? What are the tax considerations in rebalancing this account? What are the transaction fees?

Process of Rebalancing Portfolios

The process used for rebalancing can be as simple as using cash to purchase the asset class that you feel is currently underrepresented. This method should be used if your client has enough cash assets in the portfolio, or may have received a bonus and has cash available.

If it is not possible to rebalance by just buying the underperforming class, selling within the portfolio is the other option. When using this method to balance a taxable account, keep the client’s tax situation in mind. Selling can result in capital gains. You should normally avoid taking short-term gains. Waiting for the long-term holding period is simple to do.

Our firm receives reports whenever a portfolio has drifted enough to trigger an arbitrary percentage change in the asset allocation at the broad asset class level (equities and fixed income), domestic and international and at the individual asset class level (emerging markets, small-cap, real estate, etc.). This prompts the advisor to review the portfolio and, using their judgment, rebalance at that time.

The rebalancing should be written and part of the investment plan. The education of the client includes explaining that the market goes up and down daily, but the market behaves differently over the long term, and your clients need to stick with the long-term plan.

Selling within the portfolio to rebalance manages risk, but it also has an added bonus. Rebalancing allows the investor to reduce the size of the asset class that has done well (sell high) and increase the investment in the asset class that has done poorly (buy low). Rebalancing over time will produce the effect that the portfolio’s annualized return will exceed the weighted average of the annualized returns of the component asset classes.


Rebalancing is a risk-management tool for financial advisors. It should not be used to increase returns. It should be done regularly, using a disciplined approach and, it should be done whenever new investment dollars are available. By minimizing the effects of style drift, rebalancing maintains the primary factor that determines the risks and returns of a portfolio — its asset allocation.

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Karen Beardsley, CPA/PFS, CFP®, is an advisor with Capital Performance Advisors, a private wealth management firm located in Walnut Creek, California. Karen has over 30 years of tax experience and has been providing financial planning services for 10 years.