Managing your wealth can be boiled down to three key elements: protection, growth and tax reduction – with each one equally relevant to people at all asset levels.
Diversification – spreading your investments among a variety of asset classes, markets and sectors – is one of the foundational principles of good investment management.
Arriving at the right mix, or asset allocation, for your financial goals, time horizon and risk appetite is arguably the most important part of devising your investment strategy and is likely to be the main driver of returns. But although there is plenty of guidance out there to help even the novice investor work out an appropriate asset allocation, investors need to be aware that this is just the start of the story. Ensuring that you are invested to the right degree in the right assets for your needs is far from a once-and-done task.
Traditional wisdom has it that, with sufficient care, one can build a perfectly serviceable investment portfolio with fewer than twenty holdings. If the correlation between these assets, meaning their tendency to rise or fall in unison, is sufficiently low, then it may be possible for the DIY investor to put together a portfolio which – at the outset – looks pretty good in terms of diversification and therefore risk management. Yet as time goes on it is very easy for investors’ portfolios to drift away from an optimum asset allocation, impeding their ability to generate the maximum returns and possibly significantly increasing investment risk.
Portfolio drift refers to how, over time, fluctuations in the valuation of assets can skew the asset allocation set for an investment portfolio. For example, an investor may have initially allocated 20% of their portfolio to UK large-cap equities and then, as a result of the market highs in the FTSE 100 we are currently seeing, they could find that UK blue-chips have come to account for a far higher proportion of their portfolio’s overall value. While the gains in this asset class are of course no bad thing, the investor now sees that their portfolio has drifted into representing a mix of assets which may be quite far off the optimal asset allocation for their needs.
What needs to occur to get the portfolio back to its original asset allocation is known as portfolio rebalancing – a task which, while it may seem daunting to the novice investor, is actually a regular housekeeping-type task which wealth managers may carry out for their clients on a quarterly basis. But while it would be easy to assume that the professionals are at an advantage simply because they have sophisticated portfolio management systems which make things easier technically, it is actually psychological factors which may stymie the investor going it alone.
Portfolio rebalancing may call for moves which might be seen as counter-intuitive – namely selling holdings within asset classes which have outperformed compared to the others in the portfolio and buying those which have relatively underperformed to bring your portfolio back into line with your original asset allocation. This should have been very carefully devised to represent an appropriate mixture of assets likely to deliver the level of returns you seek, at the point when your financial plans require them and at a level of investment risk you feel comfortable with. This part of your investment plan will usually remain fairly stable until such time as your circumstances or goals have significantly changed (which is why wealth managers regularly meet with clients to ensure that their asset allocation and holdings remain aligned with their aims).
Although the actions required for portfolio rebalancing can feel wrong, investors always need to remember that emotions are often the enemy of investment returns, and that selling high and buying low is clearly the route to making money, rather than the opposite (all too common) tendency to pile into assets which have already had their day in terms of gains.
Portfolio rebalancing can be undertaken periodically, either quarterly, half-yearly or annually, depending on the profile of your investment portfolio, or equally it may triggered when certain asset classes breach a set tolerance for their over or under-weighting in the portfolio. In either scenario, rebalancing a portfolio is an ideal time to take a step back and reassess if tweaks need to be made to your asset allocation or indeed individual holdings. Having an ongoing dialogue about your investments which takes into account your changing financial circumstances is one of the main ways a professional adviser can add value and peace of mind.
A final consideration is the cost of rebalancing. The transaction costs associated with “churning” portfolios is a well-known drag on profits, so it is essential that any rebalancing is undertaken with this firmly in mind: if a significant cost will be incurred to make a relatively small move towards rebalancing it may be better to defer any decisions, particularly if a future development like a market correction seems likely to bring the portfolio back into line naturally. Wealth managers are adept at making these kinds of subtle calculations, while also having the inestimable advantage of being able to take a highly-objective, non-emotional view of your investments.
The need for portfolio rebalancing is something all investors need to be aware of, lest their portfolio drifts further and further away from their original investment plan and comes to represent unacceptable levels of risk or significantly reduces their ability to make attractive returns.
Delegating responsibility for regular portfolio rebalancing to a professional wealth manager might therefore be a significant weight off of investors’ minds.
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