Should you rebalance your investments during turbulent times?

Alister Sneddon, Head of Product at CMC Invest

 

The financial market is under strain with rising interest rates, and short and long term treasury bonds showing high uncertainty. This is likely to continue for the foreseeable future as we continue to recover from a period of political turbulence.

It’s in times like these that investors may review their portfolio’s performance and, as a result, they may decide to rebalance their investments. Rebalancing can be expensive and it can also constrict performance so investors must decide whether to trust their longer term strategic view, or take a tactical rebalance to embrace new opportunities.

What is rebalancing?

Most investors will be familiar with mixing uncorrelated asset classes. The most common examples are the equity and bond splits. The core principle is that they are uncorrelated and therefore the associated risk is spread, while Gold, for example, remains a safe haven and a measure of market uncertainty. However, no matter what mix of assets or exposures is created, there will come a time when the natural performance of your portfolio will cause your original allocation to skew.

For example, an investor may have started the year with a heavy allocation to US high growth and momentum technology stocks, and a small exposure to gilts and bonds. For the year to date the Nasdaq is down almost 30%, whereas a UK bond fund would have still suffered losses in the region of 6-10%. As the performance changes, the investor’s allocation is now different to the original strategic view originally decided upon. For this reason, some investors will set themselves a tolerance for when they consider their portfolio in need of rebalancing.

To rebalance their portfolio, investors need to assess which individual assets and sections have breached their allocations and trim down or top up the positions as needed to bring them back inline with the original strategic vision. However, rebalancing will often incur a variety of additional costs. A number of platforms and providers will charge commission and FX fees for each transaction (sells and buys), as well as any government taxes such as stamp duty reserve tax on individual UK equities, and finally the bid and ask spread will also create a small cost which is often ignored.

Alister Sneddon

Making tactical decisions

Some investors take a strategic approach by following their original allocation; retaining the strategic model, ideally looking from five to twenty years into the future. Whilst this plan may be adjusted over time the long term view remains unchanged.

Moving away from this strategic vision, either in response to the market, or to prepare for an event (retirement, for example), would be a tactical rebalancing of the portfolio. This involves deviating away from the original outlook and now attempting to either time the market or predict a short term outcome. Even when an investor takes a defensive stance, it’s still a tactical decision to guess the near term impact. For this reason, tactical rebalances can be tricky. When an investor takes a long term view it’s a drastic change to potentially reshuffle multiple investments and assets, and the cost impact of a rebalance can reduce the upside on any opportunity, which often sees investors holding onto their tactical portfolios for longer than intended before returning to a new or the original strategic model.

Deciding when to rebalance

Lots of things can prompt the need for rebalancing. For example, risk appetite might change, or it might be time for a new strategic (or tactical) adjustment. The investor might be changing their future view of the world, or feel there are new opportunities to be exploited.

Cost can be a big factor when it comes to deciding whether it makes sense to perform a rebalance. The fees involved can reduce the benefit of changing your approach too soon, whereas a suboptimal allocation which remains in the market for a longer period of time may be ultimately a better outcome for achieving your goals.

Where investments are held and the usage of tax wrappers can also influence when it makes sense to rebalance. Holding investments inside of an ISA or SIPP removes the extra complexity around capital gains, and dividend income is also tax free (aside from any international withholding taxes).

One aspect of investing we all tend to be emotionally challenged by is when to cut losses, when to take profits, and when to move on. A non-emotive decision with a regular rebalance can be a great way to recycle profits back into an overall long term view, rather than letting top performers risk fading over time. Locking in profits (in tax advantaged wrappers if possible) will help generate overall wealth growth rather than getting bogged down with individual asset performance. On the flip-side, if an investor believes in their other asset types, then it makes sense to use those gains to restore their original weighting.

Investors who are using a combination of tax wrappers to run the overall allocation can also make use of Bed & ISA or Bed & SIPP decisions towards the end of the tax year to move across underperforming assets which they still have a longer term view on. Generally speaking, those investors taking a longer term view will consider their investments either when they are triggered by a coming market event, or reacting to it, or on a quarterly or annual basis

Alternatives to rebalancing

Rebalancing a portfolio can be a disruptive moment, and will often represent a significant change. However, there is an alternative to rebalancing which can be achieved through the regular investing strategy.

Very few investors are lucky enough to have a lump sum amount which they will diligently manage for many years; most of us will be regularly topping up our portfolio each month and investing relatively evenly across asset types. Regular investing and dollar/pound cost averaging represents a fantastic opportunity for investors to manage their strategic allocation without triggering a rebalancing event.

Instead, investors could consider adjusting the allocation of their monthly top-ups over time to organically restore their investments to their original weighting. So, if the bonds are under performing against the equities, the investor can shift their allocation of new funds to favour bonds, helping to chip away at the imbalance over time.

This approach can also work with strategy adjustments over time too. In order to avoid having to sell down assets investors can divert new funds away and let that asset remain as it is, this avoids the portfolio becoming ‘bloated’ while the investor considers taking it in a new direction. This might be a temporary solution until a larger rebalancing and clean up of assets is required, if at all.

Another solution might be to use a satellite portfolio. This is an allocation within an investor’s overall plan which is designed to give them an edge or allocation for the unusual or tactical approaches. Rather than a 60/40 split of equities and bonds, the investor would add in a satellite allocation such as 50/30/20 where the 20% allocation can be used for tactical opportunities or to express short term views. Having a set allocation for shorter term risk like this can give a longer term investment strategy a much needed boost, while controlling how much is at risk in cash terms. This also avoids the temptation to perform drastic wholesale changes to the investment strategy for near term events, because a set amount is already allocated to be used in this way.

Is now the time to rebalance?

Right now, because there has been so much economic turbulence, most portfolios are looking extremely different from the start of the year. This can cause investors to look around at new opportunities rather than wait for a recovery of existing investments. Before rebalancing, it’s important for investors to evaluate and understand whether they want to take a longer term view or seek shorter term prospects, and how much risk they are willing to take. Is the plan to time the market or spend time in the market? Is the driver of rebalancing because the allocations are outside of the investor’s tolerance and the portfolio is no longer representing the long term view? Or is the investor taking steps against or for a potential change or a shifting market?

Investors must always consider their costs and if they need to perform a whole rebalance or if taking a different approach with how their portfolio is funded will help make adjustments while avoiding costs.

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