The Key to Keeping Your Portfolio on Track

Every spring, my mom plants her flowerpots in the backyard. She visits the various nurseries around town and loads up the car with boxes of beautiful flowers. She cannot forego picking up new soil because, of course, the foundation for any good flower garden is nutritious soil. Then, she spends hours picking and choosing which flowers should go together in the different pots around her yard, aiming to create vibrant color palettes that are always a sight to see once all the plants are in full bloom.

Keeping her flower garden captivating throughout the summer is never easy. The plants need water and fertilizer to grow and ensure they are prepared to resist the blazing summer heat. Occasionally, weeds or deadheads crop up that compete for the useful resources that are necessary to allow her flowers to bloom. Long story short, my mom’s plants won’t survive unless they are properly maintained and cared for. Your investment portfolio is no different.

There are many key pieces that go into building a financial plan. One of the most important is finding the right investment strategy for your hard-earned retirement savings. This strategy must be one that meets the unique needs of your financial situation, performance desires, and risk tolerance. Some clients have a high tolerance for risk, meaning they can stomach more exposure to the up and down gyrations of the stock market. Others have less of a risk appetite for return variability. When we set up investment strategies for our clients, we take variables like these into account, and then decide where to deploy your money so you can reach your financial goals. We call this “asset allocation.”

At HFG, we have created a series of portfolio investment models, each containing calculated and diversified asset allocations to the various investment vehicles available in today’s global capital markets. We sort these investment vehicles into their various asset classes—or groups of investments that behave similarly. We then set targets for the total percentage of your portfolio pie we want each asset class to be. Once you have had an investment discussion with your advisor and have settled on the right strategy, we memorialize your investment plan in what we call an Investment Policy Statement (IPS). Your funds are then invested into the various asset classes in accordance with your new IPS and we begin putting your money to work for you.

Just like those flowerpots, with time, your asset allocation will require maintenance because investments grow at different rates, or maybe something has happened in your life that changed your capacity for risk. Sometimes, we need to make changes to your portfolio to ensure you maintain the asset allocation that will allow you to achieve the goals set in your financial plan. This is called portfolio rebalancing.

So, what is rebalancing anyway?

Rebalancing is the act of returning one’s investment allocations back to the original model plan by buying and/or selling shares of some of the portfolio holdings to bring the allocation percentages back into “balance.” It helps keeps risk under control. Over time, as the market moves up and down, a portfolio’s holdings will drift from its original investment plan. We want to keep portfolios close to the model’s target allocation so we can realize the expected return used in our planning process with you. Allowing a portfolio to drift creates different risk and return expectations that are not in alignment with the investment model’s strategy and, therefore, your overall financial goals. This is where the maintenance piece of the portfolio management process—rebalancing—takes over.

For example, say your target asset allocation was 60% equities (e.g. stocks) and 40% fixed income (e.g. bonds). If the stock market performed well during the period, it could have increased the equity weighting of your total portfolio pie to 80%. The problem with this is that the stock market has potential for higher returns, but greater risk for losses than the fixed income asset class. To maintain your desired balance between risk and return, we would rebalance your portfolio by selling some equities and buying fixed income to get the portfolio back to the original target allocation of 60/40.

When and how do we rebalance your portfolio?

As mentioned earlier, each asset class in an HFG Trust investment model is set to be a specific percentage of the portfolio’s total balance. At HFG, we are monitoring your portfolio daily for rebalancing purposes. When any holding in the portfolio has drifted too far from its target, it is flagged for a rebalancing review.

Now, what exactly do we mean by “too far”? My mom would tell you that over-watering can certainly suffocate and kill her plants. In the investment world, rebalancing too frequently can also cause more harm than good. There is a trade-off between strictly adhering to exact investment model targets and trading costs. We believe that some drift from target allocations is acceptable, as this reduces the number of trades needed; thereby decreasing transaction costs in your portfolio and limiting tax implications that can be triggered by sales. We set minimum and maximum guardrails for acceptable drift from targets to allow for efficient portfolio management.

Your portfolio will only be flagged for rebalancing consideration if its asset class holdings drift outside the portfolio’s minimum/maximum tolerances. When a rebalance review is triggered, the most important factor to consider is aligning the risk exposure in the portfolio with its strategy, but that is not the only factor we review. We will also look at the size of the trade needed to get the portfolio into balance, your upcoming deposits or withdrawals, and tax implications (e.g. avoiding triggering short-term gains.)

The frequency with which portfolio rebalances occur can vary. There could be multiple rebalances in one quarter if we saw sharp market swings or a large distribution in your portfolio. Alternatively, there could be no rebalances over the course of a year if the portfolio didn’t drift outside of the acceptable tolerances. One strategy we do not employ, however, is automatic rebalancing on a set cadence (e.g. first day of the quarter.) Assuming the market has been flat during the year, an automated rebalance at the end of the year would incur trading costs and potentially trigger tax consequences with little to no benefit gained. Deciding when to rebalance is a balancing act between potential risk exposure within the portfolio and the transaction costs rebalancing entails.

Whenever my mom goes out of town for the weekend, I always stop by her house to water the flowers to be sure they stay healthy. No flowers will be dying on my watch. As an HFG client, rest assured that we are constantly tending to and caring for your investment portfolio.

Drew Westermeyer, CPA