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Rebalancing Your Portfolio Monthly

One popular way to get the most of of rebalancing the portfolio is to pair it with a monthly covered-call selling program.

Editor's note: Kevin Simpson is the president of Capital Wealth Planning, LLC, an investment advisory firm in Naples, Florida that specializes in managing portfolios of ETFs with a monthly covered call overlay. He can be reached at or by visiting

By Kevin Simpson



) -- How many of us consistently "buy low and sell high"? Honestly? Well, here's an opportunity to do just that. We have seen a tremendous run up in the stock markets since the March lows and the ensuing volatility one would expect has begun to settle in.

One often forgotten technique of the portfolio management puzzle is systematic rebalancing. Unfortunately, this concept fades into an afterthought all too often as procrastination is an easy ally in the fight against re-balancing. Who can blame anyone for riding the trends and deciding not to swim against the currents? It takes guts to sell your winners and re-deploy assets to out-of- favor sectors.

Systematic portfolio rebalancing is a very useful risk management technique. Over time, as different asset classes experience different returns, target-asset allocations begin to morph. This natural shift in the allocation model will expose the portfolio to risk and return characteristics that do not match your investment policy statement.

Reducing these over-concentrations will help to manage risk. The concept is simple, when one asset class, sector, or individual security outperforms the portfolio as a whole, the overall allocation shifts from your target model. This is consistently happening in all portfolios as a result of day-to-day market volatility.

An investment account allocated evenly between stocks and bonds will consistently trend in various directions. Over time, stocks have outperformed bonds and a traditional 50/50 blended stock and bond portfolio would have historically shifted to a more heavily weighted stock portfolio. That increased allocation to equities results in an inherent increased risk. Trimming back an outperforming position and rebalancing to the 50/50 original target will force a "sell high, buy low" strategy.

As with the generic example above, when markets go up with the vigor they enjoyed the second half of 2009, your equity exposure increases and with that, so does your risk level. A rebalancing strategy addresses this problem by outlining a consistent plan to review your holdings across the board -- and more importantly, to take profits in rising markets.

The core of this technique is based on proper diversification: We know that diversification must guide our investment choices. Combining different asset classes can help reduce risk, but the challenge is to determine which assets to choose and what percentage to allocate. A measure that can assist this selection process is correlation.

Correlation, when it is applied to investments, takes a deeper look at the total allocation. It serves as a measure of how different investments perform in relation to one another.

Correlation coefficients of all asset classes have been studied in great detail. For example, U.S. stocks have exhibited very little correlation with global government bonds. Meanwhile, their relationship with international stocks was much stronger -- as one would expect, since they are the same type of securities.

The potential advantages of asset allocation were first revealed by financial economists who made use of correlation and volatility data. They proved that the addition of less correlated asset classes to a portfolio could improve its overall risk/return profile. Disciplined rebalancing is the natural next step in this evolution of portfolio management.

Unfortunately for many individual investors, experience has shown that most people acquire various holdings instead of effectively building investment portfolios. The differences may be subtle, but they are important.

The first difference involves long-term planning. To build a portfolio, you need a long-term vision of what you are trying to accomplish and how it should be constructed to achieve the desired results. In acquiring a portfolio, we tend to make investment decisions based upon today's goal or today's emotion. Too often, we buy things we shouldn't own or sell things at exactly the wrong time.

Furthermore, when we acquire portfolios, we usually end up with several investment accounts (individual, joint, IRA, 401k, pension/profit sharing, etc.) that are managed independently, without regard to the investments contained in the other accounts. This leads to improper asset allocation, poor tax planning, over-concentrations and higher risk exposure than is often necessary for the return we receive. Comprehensive asset allocation is designed to reduce this problem.

Once acquired, many of these investments take on lives of their own. While their natures change with management changes, market conditions, product cycles, financial conditions, consolidations, divestitures, and legislation, they are left to grow or stagnate -- without review.

Remember the lessons of Sir John Templeton's philosophy of "buying when there's blood in the streets." Admittedly, it's hard to do. Emotional attachments that can come with individual stock ownership further complicate the issue: It's tough to sell a stock when it's moving up. It's also tough to sell a stock when it's down.

Systematic rebalancing forces you to trim down the best performing investments, while reallocating to the underperforming sectors. Determining a time frame for this practice is paramount.

One popular way to engage in a monthly rebalancing program is to pair it with a monthly covered-call selling campaign. To achieve consistent performance when writing covered calls, it is recommended that you don't get too greedy. Work with a qualified firm that sells out-of-the money contracts that expire monthly.

The premiums will not be that substantial, but this conservative approach will increase your portfolio's performance over time while limiting the chances that the underlying investment will be called away.

The first benefit of this technique is that you can use the monthly premiums to distribute into your model. Allocating the income to the underperforming asset classes will force you to add to out-of-favor sectors. More importantly, the technique always will force you to sell high. You will re-enter the called away position to your predetermined level. The profits can then be re-distributed throughout the model, further enhancing your monthly rebalancing program. This idea truly combines two complimentary investment risk reduction strategies.

Mathematical asset allocation models rebalanced systematically will help to eliminate the emotional aspect of money management, but don't forget the taxable aspect. Rebalancing in retirement accounts is a no-brainer. For taxable accounts, however, the mathematics is more challenging.

You may have loss carry forwards from previous years, which could help to offset any potential gains. Even still, you have to be aware of your holding periods for the investments you will be selling. Sometimes it may pay to wait for a long-term gain. This part can get complicated, so please consult your tax professional before rebalancing if you are at all unsure of your tax consequences.

If emotional factors play too big a role in your sell discipline, consider using ETFs instead of individual stocks. It is far easier to let go of an index when compared to selling a stock you have enjoyed following. As mentioned earlier, it's hard to know when to sell a stock. You don't want to sell something that is up because it could go higher. You don't want to sell something that has gone down, because you would at least like to recoup your initial investment. Indexing will often eliminate the natural tendencies to over think sell decisions.

When rebalancing, it is important to decide on a time frame and then stick to it! Some people re-balance annually while others go through the ritual on a weekly basis. Quarterly seems to have become somewhat of an industry standard but a monthly program may be the most effective.

To ensure a portfolio's risk and return characteristics remain consistent over time, a portfolio must be rebalanced. The most important thing to remember when rebalancing your portfolio is to make sure that you remain well-diversified. Rebalancing forces you to record gains and return your risk exposure to acceptable levels. This is an absolute necessity for the long-term investor.