Rebalancing can either happen on a schedule, such as quarterly or annually, or when an advisor notices a client owns more of a particular stock, sector or asset class than originally planned.tadamichi/Getty Images
Rising markets, even amid recent volatility, can make it difficult for disciplined investors to rebalance their portfolios.
“Rebalancing is probably hardest when it feels like everything’s working,” says Brett Gustafson, associate portfolio manager at Purpose Investments Inc. in Calgary. “It’s also a little counterintuitive: trimming winners and redeploying into things that may have also done pretty well, but not quite as well – you kind of feel like you’re giving up on what’s working.”
Still, market strategists suggest selling – or even just trimming – better-performing stocks once in a while to avoid concentration risk if those stocks correct.
This can either happen on a schedule, such as quarterly or annually, or when an advisor notices a client owns more of a particular stock, sector or asset class than originally planned. The right time to rebalance often depends on an investor’s portfolio construction, risk tolerance and investment time horizon.
Beware of the bias holding you back
Behavioural biases can sometimes prevent investors from rebalancing their portfolios, even in a rising market.
“The fear of missing out has turned into the fear of giving it back a little bit,” Mr. Gustafson says.
Recency bias may lead investors to assume that when markets are strong, recent performance will continue, he says, “so trimming the winners can feel wrong.”
He also points to loss aversion – “trimming feels like giving up potential future gains” – and overconfidence, when markets are on a run and investors credit their skill or portfolio design for the gains.
As with any investment move, there are risks with rebalancing and not rebalancing.
“The risk of not rebalancing is that you end up with a portfolio that’s not well aligned to your objectives,” says Lesley Marks, chief investment officer, equities, at Mackenzie Investments in Toronto.
For example, she says investors with a set mix of stocks and bonds may now have a much higher stock weighting given the run-up in recent years.
“And obviously, the more equities appreciate, the more vulnerable they are to a market drawdown,” she says. “So, all of a sudden, you could find yourself in a situation where you have a greater drawdown than you can stomach.”
Sadiq Adatia, chief investment officer at BMO Global Asset Management Inc., says there’s also risk of rebalancing too soon and not letting your conviction on a stock or sector play out.
“You’re always going to cap your returns because you’re selling out of them just as their momentum is building. I think that’s the big risk,” he says.
For that reason, Mr. Adatia prefers quarterly rather than monthly reviews to see if rebalancing is necessary. And if a stock is up a lot and the outlook is still good, he suggests trimming it up to half instead of selling the position entirely.
“Take some of those profits, store them and look at other areas where potentially the thesis remains sound, but it just hasn’t worked quite yet,” he says.
“It can’t just be automatic rebalancing, but a bit of smart rebalancing to say, ‘Do I believe in the winner still?’” he adds.
Mr. Gustafson likes to rebalance when he believes certain stocks or sectors are over- or underweight their targeted holdings in a portfolio.
“We prioritize the portfolio over the calendar,” he says. “Rebalancing once or twice a year is fine mechanically, but real opportunities come from watching exposures evolve through the market cycle. If you rebalance once a year, for example, you might miss out on some opportunities in the middle.”
He says rebalancing is more about discipline than prediction.
“The act of rebalancing isn’t about calling the top by any means; it’s restoring symmetry, and even small moves can help,” Mr. Gustafson says.
How advisors can talk to clients about rebalancing
Advisors can explain their rebalancing strategy to clients by highlighting that they’re not selling a stock that’s doing well, but trimming for safety, Mr. Adatia says.
“What you’re doing is just ‘risk-sizing’ the positioning,” he says. “You still get exposure, you still get the theme, but you’re just taking profits along the way, which is smart.”
Ms. Marks says advisors also need to consider tax implications when rebalancing a client’s portfolio, which could affect the timing.
She says that’s part of the rebalancing strategy advisors and clients should discuss at all of their regular checkpoints. That way, when the time comes to rebalance and take profits in an asset class or to reduce an allocation, advisors can point to the rebalancing methodology so “it doesn’t come out of nowhere,“ she says.
”Conditioning their clients that ‘this is how and when we rebalance,’ and then executing on that plan is the best way to successfully approach the conversation with your clients," she says.