Rebalancing a portfolio to manage investor composure

As anyone who has invested in equities over the long term knows, it can be a roller coaster at times. One thing that can help keep portfolios in line with the recommended and suitable level of risk is rebalancing.

A key part of the financial adviser/client relationship involves matching a client to the right portfolio for them based on their need, willingness and capacity to take risks, all linked back to the objectives contained within their plan.

Part of the challenge for advisers – particularly during times of market fluctuations - is to ensure that clients stay the course in order to give themselves the best chance of achieving the intended outcome. Nothing is more likely to destroy a carefully constructed plan than knee-jerk reactions to markets falling or a desire to chase bigger returns when markets are rising.

Rebalancing and risk control

Markets had a rocky start to 2022 and the tragic situation in Ukraine has added even more volatility. This year is a timely reminder that markets don’t always go up in a straight line and to remember the importance of risk control.

If the number one barrier to successful investment outcomes is investor composure, then you simply cannot allow a portfolio to drift to an extent where a client is now taking far more (or less) risk than was originally intended.

Even if markets have been going up and everyone feels like they are doing well, a sharp eye needs to be focused on the changing risk profile of the portfolio to be prepared for when, not if, markets decline. In behavioural finance, prospect theory tells us that people feel the negative of a loss twice as much as any pleasure from again, so it is vital to make sure investors are protected from experiencing short-term losses that may cause them to make a damaging decision.

‘Covid crash’

To better illustrate the changing risk profile of a portfolio over time we can use the ‘Covid crash’ of March 2020 as a case study. If we take two versions of a portfolio consisting of 60% invested in a simple index fund tracking the MSCI World and 40% in cash, where one portfolio is rebalanced semi-annually (the blue line below), and the other is not rebalanced at all (the red line below) we can see a very different journey for what started out as identical portfolios.

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All looks rosy for the non-rebalanced portfolio when markets are rising, but when markets fell in March 2020, we saw a very different risk profile emerge within that previously ‘better performing’ portfolio.

It is hard to dispute the fact that the non-rebalanced portfolio will have greatly increased the likelihood of the investor losing their composure and de-risking at the wrong time or worse still, going to cash and likely destroying their chance of participating in the subsequent market advance.

The PortfolioMetrix approach

The investment team at PortfolioMetrix monitors client portfolios every day to check if they need rebalancing. With the help of our proprietary technology, portfolios are monitored daily on a client-by-client basis and where a portfolio drifts by a meaningful degree from target weights (also known as trigger-based rebalancing), portfolios can be rebalanced to the client’s target allocations, as per their investment mandate.

This disciplined monitoring and rebalancing process can generate incremental returns (over 1.5% for some clients in March-April 2020 alone) and it also helps protect clients against potential behavioural obstacles such as inertia or over-confidence.