Checks & Balances

Todd Douds in Vault 25 June, 2013

checks and balancesInevitably, when there is a run-up in the markets, people begin to ask: “Is it time to sell?” At Fort Pitt Capital, we believe a strategic long-term approach is vital for success. Therefore, our answer to that question is: “Not exactly.”

In order to capture gains and take advantage of winning investments without trying to time the market, we use rebalancing in our asset allocation strategy. Periodic rebalancing allows investors to sell winners and buy losers. With a rebalancing strategy, it helps investors stay on target with their investment plan. It also acts as a risk management tool by realigning the portfolio.

Rebalancing as a risk management tool

Investors have only a few options when it comes to risk management in an asset allocation portfolio. The most common option is diversification. Diversification works because it offers exposure to diverse asset classes (e.g. US and Non-US stocks and bonds) with the intent that they perform differently in certain economic environments. The father of modern portfolio theory, Harry Markowitz, famously said that diversification is the only free lunch in finance. You have a choice of how to allocate your money.

Hedging is the second option an investor can utilize in risk management. A simple hedging strategy is to buy a put option, but that can be expensive – often times upwards of 2 to 3 percent of the portfolio every year. Ultimately, hedging with a put is like paying to insure your portfolio.

Other ways to hedge a portfolio are to use alternatives like long-short funds or to go to cash.

When to rebalance

When it comes to timing, there are a few different methods to consider. Investors can use a calendar rebalance, which is consistently rebalancing in a selected time frame – every quarter or every year, etc.

Another timing strategy is percentage of portfolio, which is rebalancing your portfolio when it reaches a certain percentage gain or a certain percentage loss. A common rule is to trigger rebalancing when there is a 5 percent shift in portfolio weightings versus the target portfolio.

Lastly, some investors prefer to sustain a consistent percentage mix of investments in their portfolio; X proportion in equities, Y in fixed income, Z in alternatives, etc. However, maintaining these percentages requires a constant rebalancing of the portfolio, which can be costly.

Rebalancing considerations for individual portfolios

First, consider transaction costs and tax implications when developing a rebalancing plan for a portfolio. Conduct a cost benefit analysis to determine the difference between frequent and infrequent rebalancing, which will help you determine timing.

Consider risk tolerance for portfolio volatility as well as overall personal risk tolerance (conservative, aggressive, etc.). A more risk tolerant investor may allow a portfolio to run further than a risk averse investor. Lastly, judge the correlation that asset classes have with each other, as well as the volatility of the asset classes, and that can determine how small or wide you want your bands to be.

Why we believe in rebalancing

At Fort Pitt Capital we believe a successful investor develops a long-term strategic investment plan specifically geared toward their unique goals and then creates a portfolio to execute on the plan. When a specific market runs up, it can shift the risk profile of a portfolio and leave the investor with a different portfolio than was originally intended. For example, if growth stocks outperform value stocks, the style tilt in a portfolio is altered and the investor could have a greater exposure to momentum in the markets thus creating a more volatile portfolio. There are unintended risks that can occur when investors choose not to rebalance.

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