By Georgdie Asprey

It’s all too easy for asset allocations to move with the whims of the market. To some investors this might not seem to be much of a problem, but when you consider that asset allocation is the primary driver of returns over the longer term, there’s a real danger when allocations drift.

We’re seeing this drift now, with the conflict in Ukraine. We saw it through the pandemic. Things can move dramatically or gradually. But they’re always moving.

This means that a painstakingly constructed portfolio, if left unattended, can end up out of balance. While many essential investment activities require careful oversight, employing a disciplined rebalancing policy should be emphasised. A disciplined rebalancing policy importantly provides risk control. It also presents the opportunity for outperformance over longer investment timeframes – particularly during market corrections or dislocations.

All portfolios will suffer drift as market forces move underlying allocations, creating new risks or opportunities. If left for extended periods, portfolio allocations will drift towards the highest-return asset, increasing overall risk of the portfolio.

Proactive rebalancing requires ongoing activity, buying and selling to bring underweight and overweight allocations to target. For example, a decline in equities and an increase in bond prices leads to the former being underweight, causing the portfolio to have lower than desired expected risk and return characteristics.

There are several forms of rebalancing:

Frequency or periodic-based – Portfolios are brought back to strategic targets at a predetermined or time-based interval: monthly, quarterly and annually

Threshold-based – When portfolios drift more than 4% from a target asset allocation, we rebalance fully back to the strategic target.

Active Rebalancing – Portfolios are rebalanced as needed, based on analysis of market conditions relative to longer-term valuations.

Like many investment activities, selecting the appropriate portfolio rebalancing program can become complicated; after all the markets are not theoretical. Moreover, investors need to comprehend there are costs involved in order to realise the long term benefits.

The complexity is magnified in turbulent markets. When markets make extreme moves, rebalancing requires substantial amounts of courage and a contrarian mindset. For psychological reasons (e.g., Recency bias & Loss aversion) the often quoted adage of being greedy when others are fearful is a lot easier said than done. As we know, investors, in general, have a difficult time adhering.

Circumstances surrounding the market pullback during the GFC illustrate the significant costs incurred by failing to conduct disciplined rebalancing activity in the face of dramatic market moves.

With the benefit of hindsight, post-crash rebalancing makes enormous sense, rewarding those with the courage to move against the crowd. There are numerous articles on the pitfalls of attempting to time the market. Many investors have lost money waiting for and anticipating corrections than in the actual corrections.

In these difficult periods, it’s important to reaffirm with clients investment timeframes and their Strategic Asset Allocations. The more they assess their portfolios in these type of environments, the more likely they are to succumb to loss aversion. Intense monitoring of portfolios will leave them susceptible to recency bias as they will naturally focus on what’s done poorly. Ultimately these biases are driven by short-termism and can lead to sub-optimal investment decisions longer-term.

At Elston, we apply Active Rebalancing to portfolios. To reiterate our approach, the starting point of our portfolios is Strategic Asset Allocation, and we believe it to be the primary driver of returns over the longer term. As for the underlying asset classes, what matters to us is if the change in price is proportional to the worsening underlying fundamentals. We are investors, not traders who take direction bets, and what an investor does is assess how the current price of a given asset compares with is its long-term value. Assessing an asset’s price relative to value remains the most reliable way to invest over the long-term.

If you would like more information please call 1300 ELSTON or contact us.