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Portfolio Rebalancing Pitfalls

Virtually every managed account uses rebalancing to ensure that your investment portfolio sticks to a certain asset allocation. This is useful but can come at the expense of selling off your winners.

How does this happen? Let’s say your financial advisor or investment manager decides to have you 65% in equities, 25% in bonds, and the rest in money markets and cash. This is a simple allocation.

What happens if your equity holdings do really well? More specifically, what happens if your Apple stock pushed your equity allocation from 65% to 75% or 80%? Your money manager will use a portfolio rebalancing tool which will get alerted that your portfolio allocation needs to be adjusted. Naturally, you’ll sell off some of your well performing Apple stock and repurchase more bonds.

What you’re really doing here is trading a higher performing stock for a lower performing bond for the sake of asset allocation—all in the name of mitigating “portfolio risk”. You cut down your winners, algorithmically, with little regard for the fundamentals.

Asset allocation is a great way of diversifying risk while investing across different markets and asset types. It allows you to choose where to invest your money, how much, and when to sell.

The selling part is where portfolio rebalancing and asset allocation can stifle returns. So often, we’ll miss out on the continued growth of our well performing investments. 

So how do we keep our winners and avoid selling for the sake of selling? Portfolio rebalancing tools are built to allow certain tolerances for when asset allocations go beyond or below those thresholds. Instead of automatically selling or buying  to reallocate we should be mindful of how individual investments within our portfolio are doing. We can choose to manually adjust our portfolio, instead of having our portfolio rebalancing tool automatically sell for us. We can use the asset allocations as guidelines instead of hard and fast rules.

If we’re paying attention, we won’t automatically do any of this. Cruise control is convenient and comfortable but it also means we’ll miss the important details along the journey. With a concentrated portfolio this becomes even more critical, where passive investing and rebalancing is often driven by autopilot and imperfect cameras and sensors.

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