One of the most important aspects of setting up an investment portfolio is analysing how much risk you are willing to accept in the pursuit of higher returns. If you have used a financial planner, they take a lot of care to find out your comfort level with risk and your investment time horizons, so that a strategy can be mapped out to accurately reflect your ‘risk/return profile’.
This then dictates the allocation of your funds proportionately to different asset classes – some in growth assets such as shares and some in more stable assets such as fixed interest investments.
Your asset allocation can get out of balance
While you may take a lot of care to structure your portfolio in line with your risk profile, it can easily and quickly get out of balance, depending on how each part of your portfolio performs. If, for example, the equity portion of your portfolio performs quite well over the short term then it can become a much greater proportion of your total portfolio and thus give your portfolio a higher level of overall risk. While this may happen unintentionally, it can create quite significant distortions if left unattended.
A simple example
Let’s say you have $100,000 to invest and after analysing your time horizon and appetite for risk your adviser recommends a moderately conservative portfolio. A possible asset allocation that would suit this portfolio could roughly have 50% allocated to capital stable investments and 50% to growth investments. This could look something like this:
• $25,000 in cash
• $25,000 in fixed interest
• $10,000 in property based managed funds
• $20,000 in Australian share funds
• $20,000 in international share funds
Let’s assume that after 12 months the share funds perform well above expectation and the values in each asset class now look like this:
• $26,000 cash
• $26,000 fixed interest
• $11,000 property based managed funds
• $25,000 Australian share funds
• $25,000 International share funds
This means the growth components of the portfolio have now grown from 50% to 54% of the total portfolio and the capital stable components have reduced from 50% to 46%. The portfolio now has a higher risk profile than you may be comfortable with and if the trend continues the distortion will gradually become greater.
What you can do to stay on track
Of course, your attitudes may change over time and you accept the extra risk, but if not then you may need to rebalance your portfolio. Rebalancing simply means adjusting the amounts in each asset class so that the proportions are reset back to the original weightings. While the principle of rebalancing makes sense, there are some issues to consider in the timing and approach you use to rebalance.
Active vs passive rebalancing
One way to rebalance is to take an active approach that involves selling some assets in your portfolio and shifting the funds to other assets. While this is the most direct way to correct an imbalance you need to consider the potential side effects, such as capital gains tax liabilities and withdrawal fees. These may have an overly detrimental impact on your portfolio.
One alternative that may remedy this is to take a passive approach to rebalancing. This could involve simply redirecting any new contributions to your portfolio toward the under-represented asset classes. This will have a more gradual impact on the asset balance.
Get some help
Everyone’s circumstances will be different, so it is important to weigh up the pros and cons of either approach. This is where the assistance of a financial adviser can help greatly. An annual review of your portfolio with an adviser can include a review to identify rebalancing issues and an objective analysis of what action should be taken.
What are your thoughts and concerns about portfolio rebalancing? Feel free to share below.
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This information was provided to the readers of WYZA courtesy of RFE Group Pty Ltd. RFE Group operates through the following entity: R Financial Educators Pty Ltd ABN 37 102 003 118; authorized representative of iPraxis Pty Ltd, AR 461048, iPraxis Pty Ltd AFSL 329337, ABN 39114365007
This is general advice only and does not take into account your financial circumstances, needs and objectives. Before making any decision based on this information, you should assess your own circumstances or seek advice from a financial planner and seek tax advice from a registered tax agent. Information is current at the date of issue and may change. WYZA Money is a partner of RFE Group Pty Ltd.