Home Adviser Fund Update Further Rebalancing Considerations Published January 20, 2021 Table of Contents Managing Rebalancing Risk Keeping Costs in Check Podcast: Dan Wiener and Jim Lowell—Investing in 2021 Adviser Investments’ Market Takeaways In a recent Adviser Fund Update, we analyzed several rebalancing strategies recommended by Fidelity and Vanguard. After putting the data through its paces, we discovered that over two decades, there was little difference in returns between portfolios that were rebalanced periodically and those that were not. For more detail, please refer to our January 6, 2021 update. In today’s update, we will explore rebalancing’s role in riskThe probability that an investment will decline in value in the short term, along with the magnitude of that decline. Stocks are often considered riskier than bonds because they have a higher probability of losing money, and they tend to lose more than bonds when they do decline. prevention, tax strategy and managing the fees and costs associated with rebalancing. Managing Rebalancing RiskThe probability that an investment will decline in value in the short term, along with the magnitude of that decline. Stocks are often considered riskier than bonds because they have a higher probability of losing money, and they tend to lose more than bonds when they do decline. Advocates of rebalancing argue that the technique reinforces discipline to sell winners high and buy market laggards at a discount. By sticking strictly to a defined allocation between stocksA financial instrument giving the holder a proportion of the ownership and earnings of a company. and bondsA financial instrument representing an IOU from the borrower to the lender. Bond issuers promise to pay bond holders a given amount of interest for a pre-determined amount of time until the loan is repaid in full (otherwise known as the maturity date). Bonds can have a fixed or floating interest rate. Fixed-rate bonds pay out a pre-determined amount of interest each year, while floating-rate bonds can pay higher or lower interest each year depending on prevailing market interest rates., risk-control rebalancers believe you are managing the overall risk or volatilityA measure of how large the changes in an asset’s price are. The more volatile an asset, the more likely that its price will experience sharp rises and steep drops over time. The more volatile an asset is, the riskier it is to invest in. of your portfolio consistently across market cycles. Mathematically, this is absolutely true. A portfolio that’s regularly rebalanced typically does exhibit lower volatility, resulting in a better risk-adjusted return over time, even if its total returns closely hew to even or lag a portfolio that is never rebalanced. Investors need to consider the various costs associated with rebalancing, mentioned below, and decide for themselves what that risk control is worth to them. The Adviser Investments philosophy is to make strategic trades when opportunities present themselves, rather than engage in regular or systematic trades (unless it’s something specifically requested by a client to meet their financial or investment needs). Keeping Costs in Check Perhaps the biggest negative about becoming a rebalancing fanatic? Cost. In conducting our analysis, we assumed that every distribution was reinvested along the way and didn’t include transaction fees or realized gains from trades—critical issues when considering a rebalancing strategy. If you decide to employ annual rebalancing (or something more frequent) in a taxable portfolio, carefully review how the various transactions will impact your taxes on top of any fees you might incur. It’s key to consider: Do funds in your portfolio have front- or back-end loads or short-term trading fees? Does the fund you’re buying make regular distributions? (Some funds pay annually; others quarterly or monthly.) Will selling your shares create a taxable gain? (This is obviously not an issue in tax-deferred accounts like IRAs and 401(k)s, but trading fees and loads should still be considered.) Thinking through these questions may lead you to see that the hidden costs of rebalancing can suck the wind out of your portfolio’s sails and be a drag on returns. Still, there are more ways to rebalance than buying and selling funds on a fixed schedule or when allocations get out of whack. An alternative is redirecting your existing distributions or making new investments in under-allocated funds within your portfolio. If you are counting on your portfolio for income, you could sell more shares of your winners to reduce their allocation. (This will create its own tax liabilityLiabilities are calculated by adding up your existing debts (mortgage, car loans, student loans, credit cards, etc.)., but you can’t avoid taxes forever if you’re drawing down your portfolio.) Moves like this can keep taxes and expenses down, compared to making numerous trades over the course of a year. Managing Emotions Another thing to consider when you rebalance: You’re only human. Many investors find it tough to act rationally when their money is on the line. Rebalancing often requires you to reward the losers in your portfolio while reducing your exposure to proven winners. If you have a fund in your portfolio that’s been outperforming month after month, you’re probably not in a rush to sell it to invest more in a fund that’s been losing. Yet, the central theory underpinning rebalancing requires you to do just that. Over and over again. As Vanguard founder Jack Bogle once put it: “If you are going to rebalance, you have to be absolutely clinical, or you are better off not doing it.” Other Rebalancing Considerations Before you make your mind up about rebalancing, here are a few additional things to consider: Your goals and objectives. If you do choose to rebalance, on a set schedule or when your portfolio’s allocation moves past a predetermined threshold, is your target allocation still on track? Do you have the same investment goals as when you started? Has your risk comfort zone shifted? Over a decades-long period like the one we examined in our analysis, your desired allocation may change, requiring even more buying and selling. The time and effort needed. Have you set aside time to make multiple trades? Many firms offer online trading, but you’ll still need to review paperwork and disclosures, track every change to make sure there weren’t any errors and fill in extra lines on your tax return for capital gains. The discipline required. If you’re following a portfolio-drift scheme, will you be able to track changes and trade at the right times? You could be in for flurries of trades over a short period of time or years of waiting. Since there’s no routine, you’ll need to pay close attention to execute at the right times. So is rebalancing necessary? Even though the financial press (or your fund company) may have you thinking so, the evidence shows that there is little benefit when it comes to the portfolio’s returns, and only some benefit when taking risk into account. (Again, that’s assuming no tax consequences or trading fees.) That said, if rebalancing regularly provides peace of mind and you’re willing to be clinical about it, your portfolio likely won’t suffer much as a result. Podcast: Dan Wiener and Jim Lowell—Investing in 2021 The turbulence of 2020 hasn’t settled down in 2021—and it’s more important than ever to look forward when considering both obstacles and opportunities. In this week’s podcast, Adviser Investments Chairman Dan Wiener and Chief Investment Officer Jim Lowell provide a bird’s-eye view of the trends and themes they see shaping the investment landscape in 2021. This discussion covers a range of big-picture concerns and questions, including: Will the economy finally move past COVID-19 in 2021? Is the market in a bubble—or just bitcoin? Income generation in a low-yield environment The state of the U.S.–China relationship and the global economy Has the time finally come for value stocksA stock that is statistically cheap as a multiple of its earnings or book value, as compared to the overall stock market. to shine? Click here to listen now! And be sure to tune in next time for a drilled-down discussion with our research team about how they see these trends playing out in the areas they focus on—and how they are influencing our investment recommendations. Adviser Investments’ Market Takeaways There’s no shortage of hyperbolic headlines and provocative punditry in the financial media. But you won’t find such hysterics here. In Today’s Market Takeaways, members of our investment team provide timely videos that clearly and concisely explain what we’re seeing in the markets. Research Analyst Liz Laprade reviewed the continued strength of small-cap stocks in 2021 after last year’s rally. And Vice President Steve Johnson explained the most significant letter on Wall Street: “B” for Biden, billions, bonds, bitcoin and bubbles. We hope you find them engaging and accessible, and please let us know if there are any topics you’d like to hear us address by sending an email to firstname.lastname@example.org About Adviser Investments Adviser Investments is a full service wealth management firm, offering investment management, financial and tax planning, managed individual bond portfolios, and 401(k) advisory services. We’ve been helping individuals, trustsA legal document that functions as an instruction manual to how you want your money managed and spent in your later years as well as how your assets should be distributed after your death. 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