The beginning of a new year is a time when many active style investors take a close look at their portfolios to chart a course for the new year. Even for those who undertake a passive index based approachto investing, like the one we suggest, there are still decisions that need to be made each year with the central one of these relating to the rebalancing of portfolio investments. (Take a look at our Building Portfolios
page for more details about our approach.)
So what is rebalancing, why should you be doing it and how do we think you should be undertaking this process in current conditions?
The academic literature suggests that 95% of the future returns from a portfolio can be explained by the choice of asset allocation made by the investor. i.e. how much of the portfolio is invested in cash, fixed interest, Australian shares, international shares and property. This therefore is the key decision to be considered when establishing and then reviewing an investment portfolio.
These asset allocations will change over the course of a year as certain asset classes grow in value while others fall. In 2008, cash and fixed interest assets generally performed well while international shares, Australian shares and listed property all lost considerable value leaving portfolios with higher proportions of cash and fixed interest compared to the beginning of the year.
Rebalancing is the act of bringing the portfolio back exactly or close to your ideal asset allocation. To achieve this you generally need to sell some of those assets that have performed well over the period and buy those which have performed poorly. What this forces you to do is follow the widely accepted fundamental rule of investing - buy at low prices and sell at high prices.
When growth assets are performing well, this tends to be an easier process to follow by selling some of you growth assets to top up your cash and fixed interest investments compared to a situation like the present where growth assets have significantly fallen in value. Many investors find it hard to be investing back into growth assets after a year like 2008.
To be frank the current climate is a difficult one to be taking the plunge back into shares. Our approach in the current climate is to utilise a dollar cost averaging approach to gradually build up growth assets over time. For instance you might decided that you want to use $24,000 of your cash to buy growth assets. Or approach would be to invest $1,000 per month over the next 24 months into these growth assets. We do this because we can not be certain that growth asset values will rise from here. They may fall further. Investing gradually over a two year period should provide protection even if such falls do occur.
On the other hand, shares may boom from here. In such circumstances dollar cost averaging does not make as good sense as you will be buying assets at higher prices.
Finally it is good to consider when is the best time to undertake a rebalancing of your portfolio. If you take a dollar cost averaging drip feed approach the timing is not as crucial. If you were to use a once off rebalance whereby you only rebalance at one time every year then it might be best to wait until distributions / dividends have been received and use this cash to make the new asset purchases at that time.
Some suggest that you don't need to rebalance your portfolio at all, rather just start with your ideal asset allocation and let the markets adapt that asset allocation through the upward and downward price movements. Our firm's approach is that it is worth reviewing asset allocation at least once every year and by doing so get in the habit of buying when values are relatively low.