Importance of Monitoring and 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 this sets the foundation for how the investments need to be treated on an ongoing basis. When we talk about assessing risk, we are in essence putting the ingredients together to make the perfect recipe. If I were to be baking a cake for example, I would want to make sure what the precise amount of eggs, flour, sugar and butter is 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 could turn out greasy and not 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 needs of the client, a portfolio is recommended for what percentage would be allocated to stocks or equities and what percentage would be allocated 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 and the 40% represents the amount allocated to fixed income. We then would move the funds that are received into that allocation to be monitored over time to make sure the allocation stays within that range.

One important note is that this allocation is not something to be married to. As time goes on with the relationship, certain changes could be recommended to cater to the client’s needs at that time. One of the more popular times we see the biggest change in the original allocation is when a client is transitioning into retirement. This would be a time we look at moving 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 the assets, we mean that we are looking constantly at market conditions for each asset class to make sure it stays within the specified risk tolerance. This is where rebalancing could play a critical role in maintaining the overall health of the portfolio in ensuring that it remains aligned with the financial goals of the client. 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 could start to see too much or too little of a particular ingredient making our cake not turn out the way we want it to. If we have too little or too much exposure within a particular asset class, we could be increasing our risk or potentially reducing the portfolio’s long-term returns.

For example, over the last 12 months, First Financial Trust’s Managed Core 60/40 portfolio has generated returns in excess of 15%, with about 23 percentage points coming from equities and about 4 percentage points coming from fixed income. As you can see from that example, the equities have greatly outperformed the fixed income. Therefore, we would start to see portfolios drift up in equity exposure and be over-allocated to that asset class, which would incrementally step-up the overall risk profile. This would be the time for us to step in to discuss the strategy of how to shift market gains from equities to fixed income to preserve the funds accumulated and keep the assets within the target allocation. Rebalancing a portfolio helps to:

• Reduce Volatility – Rebalancing helps minimize portfolio fluctuations.
• 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 talking with clients each year, we are looking at many different data points of their finances, but we will always make sure to look at their overall allocation in comparison to the set objective. We recommend looking at your investments yearly, however there may be certain times that it is warranted to look at them more frequently. It all depends on the amount of market fluctuation in each time frame of reference. Once an asset allocation has strayed 5-10 percentage points from the set objective (i.e., 60/40 portfolio is now a 70/30) 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 result in overtrading which could negatively impact 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 is needed 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 make sure the cake that you love to bake turns out the same every time. If you are wanting to discuss your overall financial plan and investment objectives, we would love to help serve you.