When setting up an investment portfolio, deciding on the correct asset allocation is an important part of that process.
Over time, however, the balance of the portfolio will change as some asset classes perform above expectation, and some below expectation. What should you do about this?
I attended a seminar yesterday that looked at exactly this question.
While the simplistic answer is that once the asset allocation gets out of line with your expectations, you should bring in back into line, we have to keep in mind that there are costs associated with such a move. The most significant cost is capital gains tax. Selling assets in the part of a portfolio that has performed strongly will mean that capital gains tax is realised.
The most effective way to rebalance a portfolio is to use the portfolio income and additional portfolio contributions to bring the portfolio back towards you preferred asset allocation. That way you are not selling assets and realising capital gains tax. You are simply using the portfolio income and contributions to strategically increase the exposure to asset classes that are underrepresented in your portfolio.
Of course, once a person retires, they are more than likely going to be spending the portfolio income and no longer making additional portfolio contributions. What about their situation? In Australia, once a superannuation fund has started to pay an income stream, the fund becomes completely tax expempt. In that case there is no need to worry about capital gains tax when rebalancing.
A large part of our annual review process focusses on forming a plan for the best use of the portfolio income and future contribution to the portfolio - ensuring that they are invested in such a way as to keep the portfolio true to your asset allocation, and your overall financial goals.