The importance of rebalancing a portfolio to manage investor composure

Rebalancing keeps clients’ portfolios in line with their recommended and suitable level of risk over time and increases the likelihood of them successfully navigating the inevitable roller coaster ride of investing for the long term.

Financial planning, in the context of investments, is the process of matching a client to the right portfolio for them based on their need, willingness and capacity to take risk, all linked back to the objectives contained within their plan. An adviser’s key role is then to ensure that the client stays 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

The MSCI World rose a staggering 30% in Euro terms in 2021. However, markets have had a rocky start to 2022 with the MSCI World down about 7% in Euro terms over the first eight weeks. This is a timely reminder that markets don’t always go up and therefore a good opportunity to remind ourselves of the importance of risk control and rebalancing.

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 risk than was originally intended. Even if markets have been going up and everyone feels like they are doing very 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 weigh losses twice as heavy as gains, so it is vital to make sure investors are protected from experiencing short-term losses that are too large for them to handle.

A case study

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 naïve 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 green 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.

rebalancing graph

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 volatility of that non-rebalanced portfolio would in fact have increased from a 4 to a 5 if we think of it through the lens of ESMA or SRRI risk methodologies.

The PortfolioMetrix approach

At PortfolioMetrix we take rebalancing seriously. Through the use of 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, per their investment mandate, which are based on a long-term outlook and not short-term emotional reactions. No crystal ball gazing is taking place, it is just a disciplined monitoring and rebalancing process. This process helps protect against potential behavioural obstacles such as inertia or over-confidence.