Importance of Monitoring & Rebalancing Your Portfolio

One of the first steps we take at First Financial Trust when establishing a relationship with a client is to understand their risk tolerance. This is a critical step, as it sets the foundation for how investments need to be treated on an ongoing basis. When we discuss assessing risk, we are, in essence, combining the ingredients to create the perfect recipe. If I were to bake a cake, for example, I would want to ensure that I know the precise quantities of eggs, flour, sugar, and butter needed. I know that if I have too many eggs, the recipe could turn out spongy or rubbery. If I have too little flour, the recipe may turn out greasy and fail to rise to the desired shape or texture. Translating this to the investments, if I have too much exposure to equities in the portfolio, I may be taking on more risk by subjecting a higher percentage of my money to volatility. Whereas if I have too much fixed income exposure, I may not be able to make my investments last for the duration of my financial plan.

Once a risk tolerance is assessed and accepted based on the client's needs, a portfolio is recommended, specifying the percentage to be allocated to stocks or equities and the percentage to be assigned to bonds or fixed income. For example, if I were to say we are going to establish a 60/40 allocation, this means that the 60% represents the amount allocated to equities. The 40% represents the amount allocated to fixed income. We would then transfer the received funds into that allocation, which would be monitored over time to ensure the allocation stays within the specified range.

One important note is that this allocation is not something to be married to; it is merely a guideline. As time progresses in the relationship, specific adjustments may be recommended to cater to the client's evolving needs. One of the most notable times we see the most significant change in the original allocation is when a client transitions into retirement. This would be a time to consider transitioning to a more conservative portfolio to preserve the assets that have been accumulated. We would oftentimes still recommend some degree of equity exposure, but maybe not as high as it was when they were working.

When we discuss monitoring of assets, we mean that we constantly review market conditions for each asset class to ensure it remains within the specified risk tolerance. This is where rebalancing can play a critical role in maintaining the overall health of the portfolio, ensuring it remains aligned with the client's financial goals. Despite its importance, many investors unfortunately overlook this critical task.

Why Rebalancing is Necessary

When investing for the long term, a portfolio's asset allocation will change due to market fluctuations. This will cause the individual classes of assets to stray from the original target. Referring to our recipe example above, we can start to see that there is too much or too little of a particular ingredient, which can make our cake not turn out the way we want it to. If we have too little or too much exposure in a specific asset class, we could be increasing our risk or potentially reducing the portfolio's long-term returns.

For example, in 2024, the S&P 500 generated returns exceeding 25%, while the S&P U.S. Aggregate Bond Index generated approximately 2.50%. As you can see from that example, the equities have significantly outperformed the fixed income. Therefore, we would start to see portfolios drift upward in equity exposure and become over-allocated to that asset class, which would incrementally increase the overall risk profile. This would be the time for us to step in and discuss the strategy for shifting market gains from equities to fixed income, thereby preserving the accumulated funds and maintaining the assets within the target allocation. Rebalancing a portfolio helps to:

• Reduce Volatility – Rebalancing helps minimize fluctuations in your portfolio.
• Improve Returns – Regular rebalancing can lead to better long-term performance.
• Enhance Discipline – Encourages investors to stay focused on the investment strategy.

When to Rebalance

When speaking with clients each year, we examine various financial data points, but we always ensure that we compare their overall allocation to the established objective. We recommend reviewing your investments annually; however, there may be certain times when it is warranted to do so more frequently. It all depends on the amount of market fluctuation in each time frame of reference. Once an asset allocation has deviated 5-10 percentage points from its set objective (i.e., a 60/40 portfolio is now a 70/30 portfolio), it is a good time to discuss a possible rebalance.

Additional Considerations

• Frequent Checking – Avoid checking your investments too frequently (daily/weekly). This can lead to a sense of needing to act when in fact you do not. This could lead to overtrading, potentially negatively impacting long-term returns.
• Tax Considerations – When rebalancing in a qualified account (401k, 403(b), IRAs), you do not have to worry about the tax consequences, as these are all tax-deferred accounts. You must always check what needs to be sold in after-tax/brokerage accounts, as these will trigger tax consequences when selling the investments. You can help mitigate this by selling losing positions to offset capital gains through tax loss harvesting.

The winning route will always be the one that works for the overall goals of your financial plan. We always want to ensure that the cake you love to bake turns out the same every time. If you're going to discuss your overall financial plan and investment objectives, we'd be happy to help serve you.