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Discussing Portfolio Rebalancing in a Market Downturn

Recent volatility in the financial markets is the idea time for investors and financial advisers to discuss diversification, asset allocation, taxes and long-term goals.

The recent stock market decline in the wake of the coronavirus pandemic has left the asset allocation of many investors' portfolios well off of their target allocations. This is an appropriate time for financial advisers and their clients to discuss rebalancing and to revisit why it’s an important part of the investing process.

The recent decline in the stock market has likely had a bigger impact on investors’ allocation to stocks than to their allocations to bonds or cash. Beyond just stocks in general, the declines have been uneven among sub-asset classes like domestic small-cap or international stocks. Further, the declines were different between value-oriented and growth-oriented stocks.

As their financial adviser, the investment strategy you’ve put in place for your clients certainly includes a target asset allocation that is aligned with their overall financial plan. This plan, in turn, is likely based on the client’s time horizon for the money, their risk tolerance and their overall financial goals.

While it may not seem like it to some clients, the decline in their allocation to stocks has left them in the position of possibly taking too little risk with their portfolio going forward. This can put them in the position of falling short of the financial goals their investment plan was designed to help them achieve.

Diversification Is Critical

The idea behind having a target asset allocation is that diversification is a key factor in minimizing downside risk over time, while seeking to maximize risk-adjusted returns. While it might feel more comfortable for some investors to allow their allocation to stocks to remain low during periods of market volatility, it’s important to show them why this might not be a good idea for them over the long haul.

Over time different types of investments perform differently. Having a combination of asset classes that are not all highly correlated with each other represented in your client’s portfolios can actually reduce the volatility of their portfolios over time. While you’ve surely discussed this with your clients in the past, periods of market volatility are a good time to review these concepts with your clients.

Depending upon how long you’ve been working with a particular client, you may be able to show them the benefits of this diversification on their portfolio over time, including during the current period of market volatility.

Use Rebalancing Rules

Two of the most common rules for rebalancing are the passage of time or a percentage deviation from the target allocation by a specified percentage.

If you have rebalancing rules in place that are triggered by a specified deviation from the portfolio’s target asset allocation, it may be that the recent market volatility has triggered a rebalancing point.

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If rebalancing is normally a function of the passage of a set interval of time, it may make sense to discuss doing rebalancing sooner than the normal time frame if you feel it is appropriate for your client’s portfolio to position them for the future.

Those who try to time the market usually get it wrong. This is especially true for those investors who are not professional traders and who are not “in the market” on a daily basis. In communicating with your clients about the importance of rebalancing, you might stress that failing to rebalance is in many ways like trying to time the market. This holds true both when stocks are at high levels and when they are down as in the present situation.

Your rebalancing discussion might also include that the rebalancing process is a form of discipline and that successful long-term investors often attribute their success to having an investment discipline.

Rebalancing Tactics

Your discussion should include different ways to implement rebalancing besides strictly buying and selling holdings.

Use new money to do some or all of the rebalancing. This might include ongoing contributions to a 401(k) or similar workplace retirement account. It could also include contributions to an IRA or new money available to invest in a taxable account. This new money would be directed towards asset classes that are currently under allocated. While this might not totally rectify the issue, it can help at least in part.

Use tax-loss harvesting where applicable in taxable accounts. This can help offset the tax impact of any taxable investments sold at a gain during the process, plus any capital gains distributions seen during the year from mutual funds. Additionally, up to $3,000 of any losses for the year in excess of gains can be used to offset other income, with the rest carried over to subsequent tax years. This can be a good planning tool.

A Good Time to Review

Rebalancing, especially as the result of a market downturn, is a good time to review target allocation in the context of an overall financial plan. This accomplishes two things. First this is something you are likely to do anyhow, doing it when the markets have dropped a bit allows you to satisfy yourself that either the client’s target allocation makes sense as is, or perhaps some tweaks are needed. This review should include a look both at their asset allocation and the particular securities being used to implement the allocation, especially if these consist of actively managed mutual funds or individual stocks.

Second, this is a good way to show your clients that you are truly looking at their investments in light of their overall situation. You know your clients best, but all of them will likely appreciate this approach, especially those who might be feeling a bit of anxiety in this market environment.

Rebalancing is a key part of a long-term investing approach and is an important tool in helping your clients maintain a balance in their portfolio that reflects their goals, time horizon and risk tolerance. Discussing this aspect of their investment strategy periodically is a good way to reinforce the importance that you place on it.