Creating a low-cost globally diversified portfolio is an optimal way to make sure your investments are working efficiently, something Wealth Legacy Institute recommends using our Intelligent Investing™ process. However, this is only part of the equation for a successful investment experience. You also need a plan for tracking and rebalancing your portfolio allocation.
When a particular investment is doing well, it feels great at first, but can have dangerous consequences in the long run. Committing to a rebalancing process is a disciplined way to consistently buy low and sell high.
Monitoring “Drift”
Over time investments in your portfolio will go up and down, moving your portfolio away from its target allocation. The difference between your target allocation and your actual allocation is called “drift.” Wealth Legacy Institute defines drift as the sum of the absolute deviation (the difference) between the target and the current allocation for each investment in the portfolio, divided by two. Here’s a simplified example using four investments:
Deciding When to Rebalance
Allowing portfolios to have some drift is okay, as this saves on trading costs and helps manage capital gains. At Wealth Legacy Institute, we use a drift threshold of 5% to determine when a portfolio should be evaluated for rebalancing. When reviewing portfolios that have reached our drift threshold, we consider risk exposures, the number of trades to get the portfolio back to its target allocation, and tax implications.
There are other instances when a portfolio may need to be rebalanced outside of movements in the market. One example is Cash Flow rebalancing, which involves rebalancing the portfolio when deposits come in, dividends are paid or withdrawals are made, particularly for retirement income. Cash Flow rebalancing allows you to rebalance the portfolio with fewer trades by only selling (or buying) specific investments that are out of tolerance.
Rebalancing your portfolio brings your investments back into alignment with their target allocation. The main benefits of rebalancing are:
- reduces risk by ensuring your portfolio lines up with your target allocation; an allocation which is designed to manage risk
- removes emotions from your investment decision-making
- provides you with a more consistent investment experience, as asset allocation is the primary driver of a portfolio’s risk and return
Improving your Investment Experience
Rebalancing your portfolio is like a car tune up - it ensures everything is working correctly and helps you avoid more costly repairs down the road. A documented process for rebalancing keeps your allocation in alignment with your target allocation and helps you stick to your plan regardless of what the market does. Unfortunately, many investors do not have a plan to manage these portfolio shifts and suffer real world consequences, jeopardizing their retirement success. When you follow a rebalancing process, you make sound decisions separate from your current feelings. This leads to a more successful investing experience over the long term.
Finding a fiduciary financial advisor who is bound to act in your best interest will help you keep track of your portfolio, ensuring that you return to your target allocation when too much drifting occurs. This will not only help your returns, but also keep you on the path to reach your retirement objectives.
To learn what questions to ask an advisor to find out if they are a fiduciary acting in your best interest, download our free Fiduciary Oath guidebook.
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