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Rebalancing resolutions

As life shifts out of holiday mode and we transition back to normal day to day routines, ...

... will your plans to turn investment ambitions into reality go the same way as those New Year's resolutions to eat better, exercise more, and finish that lingering DIY project?


For many investors - particularly those with a self-managed superannuation fund - the beginning of a new year is a timely opportunity to reflect on how your portfolio is tracking and to consider rebalancing to bring the asset allocation back in line with your personal risk profile.

Rebalancing, the discipline of adjusting investments to come back into line with your desired asset allocation, like many of our New Year's resolutions, is an activity that is a lot easier said than done.

Positive returns from the markets may tempt many investors to disregard the rational and disciplined approach of taking the time to review financial plans, factor in any change of circumstances, and consider whether there is a need to rebalance the investment portfolio back to its defined asset allocation.

Looking at the performance of the various asset classes across 2014, you can see the usual mix of good, middling and poor: Australian listed property performed strongly, returning just under 27 per cent, while domestic and international fixed income classes yielded 9.8 and 11 per cent respectively. Overall, investors are likely to be more satisfied than celebratory, because while all of the major asset classes achieved positive returns, the fall away in the Australian sharemarket in November and December meant it finished the year up a more modest 5.3 per cent.

You don't need a detailed understanding of behavioural finance theories to appreciate how difficult it can be to sell out of an asset class with returns that have exceeded expectations; at face value it may actually appear counter intuitive.

After a year of strong performance in 2013 and more subdued returns in 2014 (using the benchmark for Vanguard's Balanced Index Fund to illustrate, returns were approximately 11.1 per cent in 2014, compared with 14.7 per cent in 2013), rebalancing may involve investors selling their best-performing assets and committing more capital to asset classes which, on face value, have recently underperformed.

This is where rational investment theory and behavioural finance collide.

The emotional reaction is to procrastinate because it means selling 'winners' and buying 'losers' - with the likelihood you may crystallise a capital gains tax bill, unless you can rebalance using new cash flows.

The rational, unemotional action to take is to rebalance back to your asset allocation target to maintain the portfolio's risk within the parameters you set when constructing the initial portfolio and financial plan.

To use the global financial crisis as an extreme example, in the lead up to the GFC a rebalancing approach would have seen investors selling out of the highest performing asset classes - equities - and buying into defensive investments like bonds with much lower return levels. That all changed when the GFC hit and then rebalancing would have meant selling out of the security of bonds and buying high risk equities.

Such is the emotional roller coaster of investing at times.

All this, of course, assumes that you are working to a financial plan with an asset allocation that considers your risk tolerances and aligns with your financial goals.

Within a financial plan, it is important for investors to develop a rebalancing strategy that formally addresses the questions - 'how often, how far, and how much'. That is, how frequently the portfolio should be monitored; how far an asset allocation can be allowed to deviate from its target before it is rebalanced; and whether periodic rebalancing should restore a portfolio to its target or to a close approximation of the target.

Rebalancing and sticking to a long-term portfolio plan is also an area where a good financial adviser can add significant value - by offering an impartial, non-emotional perspective.

As a rule of thumb, monitoring on an annual or semi-annual basis and rebalancing when asset allocations exceed thresholds of 5 per cent usually work for most broadly diversified portfolios.

If you are lucky enough to be enjoying a break through January, revisiting or refining your long-term financial plan is an investment of time likely to pay off for much longer than just the year ahead.

By Robin Bowerman
Smart Investing
Principal & Head of Retail, Vanguard Investments Australia
15th January 2015