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| > Investing > Fiduciary Focus |
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| Reallocation Versus Rebalancing |
| by
W. Scott Simon
| 03-05-09 |
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The allocation of many portfolios has changed as a result of significant movements in financial markets, especially over the last six months. Given this broad disarray in financial markets, advisors might find a brief discussion about the difference between (1) rebalancing a portfolio's current asset allocation and (2) outright changing a portfolio's target asset allocation to be of interest.
Asset Allocation
"Asset allocation" is the way in which investable money is distributed among the asset classes in a portfolio. Commentary to the Restatement (Third) of Trusts (Prudent Investor Rule) explains: "Asset allocation decisions . deal with the categories of investments to be included in a trust portfolio and the portions of the trust estate to be allocated to each. These decisions are subject to adjustment from time to time as changes occur in economic conditions or expectations or in the needs or investment objectives of the trust." (Section 227, comment g, pages 25-26.) William F. Sharpe, a 1990 Nobel laureate, observes: "It is generally agreed by theoreticians and practitioners alike that the asset allocation decision is by far the most important made by the investor."
Rebalancing a Portfolio's Current Asset Allocation
Rebalancing is a systematic, unemotional way to purchase more securities to add to a portfolio and sell existing securities from it in order to move the portfolio's current asset allocation toward its target asset allocation. Suppose, for example, that the stock market takes a tumble and as a result a portfolio's current allocation is 60% stocks and 40% fixed-income investments, but that the portfolio's target allocation is 70% stocks and 30% fixed-income investments. An investor would need to buy more stocks and sell some bonds in order to rebalance the portfolio.
It's obvious that normal (or abnormal) movements in financial markets will cause a portfolio's resultant asset allocation to deviate from its target allocation from time to time. The continuous rebalancing of a portfolio back toward its target allocation, however, can generate significant costs (and taxes for taxable investors) that, of course, have a negative impact on bottom line portfolio performance.
That's why it makes sense ordinarily to establish a minimum and maximum range by which a portfolio's current allocation may deviate from its target allocation. For example, suppose that a portfolio's target allocation is 70% stocks and 30% fixed income investments and the range by which the portfolio's current allocation may deviate from its target allocation is ten percentage points. This means that the portfolio's current allocation could range from a minimum of 60% to a maximum of 80% for stocks and from a minimum of 20% to a maximum of 40% for fixed income investments. The use of such a range helps limit the impact of any costs on portfolio return that could otherwise be generated as a result of unnecessary portfolio rebalancing.
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| W. Scott Simon is an expert on the Uniform Prudent Investor Act and the Restatement 3rd of Trusts (Prudent Investor Rule). He is the author of two books, one of which, The Prudent Investor Act: A Guide to Understanding is the definitive work on modern prudent fiduciary investing. Simon provides services as a consultant and expert witness on fiduciary issues in litigation and arbitrations. He is a member of the State Bar of California, a Certified Financial Planner, and an Accredited Investment Fiduciary Analyst. Simon's certification as an AIFA qualifies him to conduct independent fiduciary reviews for those concerned about their responsibilities investing the assets of endowments and foundations, ERISA retirement plans, private family trusts, public employee retirement plans as well as high net worth individuals. For more information about Simon, please visitPrudent Investor Advisors, or you can e-mail him at wssimon@prudentllc.com The author is not an employee of Morningstar, Inc. The views expressed in this article are the author's. They do not necessarily reflect the views of Morningstar. |
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