Put Discipline In Your Portfolio

Guest Blogger:  Every now and then, we come across a great blog written by a fellow Fee-Only Financial Planner.  We ask their permission to allow us to repost the blog on our website to share the knowledge.  Thank you Ray Mignone of Mignone & Associates Inc. for sharing the following blog: Put Discipline In Your Portfolio.

Written by Ray Mignone | 18 September 2012

Many investors don’t have a disciplined approach to investing and therefore don’t maximize their performance. A professional fee-only certified financial planner or investment advisor usually has better performance than the individual investor even after fees, why? I believe the reason involves two main criteria neither of which has anything to do with consistent outstanding investment selection. I believe the reason for the better performance has to do with putting discipline into the investment process and taking emotions out of the investment process.

Emotions Cause Bad Investment Decisions

Individual investors allow their emotions to cause them to make bad investment decisions, study after study show how most people buy when the market is already sky high and sell when the market is down and cheap. In this article I want to discuss the other area that I think you could increase your investment returns and that is by having a disciplined strategy of rebalancing your portfolio.

Rebalance Portfolios Periodically

Now most investors know they should rebalance their portfolios periodically to ensure they stay in line with a targeted asset allocation strategy, good investment management practices require it. Why, then, is it so difficult for most investors to do this? The pri­mary reason is that rebalancing goes against our basic instincts. With rebalancing, you are generally sell­ing those investments performing well to purchase those that are underperforming, which just doesn’t seem to make sense. It might help to remember that by rebalancing, you are following a fundamental invest­ment principle — you are buying low (those investments that are underperforming) and selling high (those investments that are perform­ing well).

Numerous studies have shown that rebalancing reduces the volatili­ty in portfolios, often with increased returns. Keep in mind that you set your asset allocation strategy because you believed those were the appropriate percentages of various investments that you should own. Thus, you need to make rebalancing a habit so your portfolio doesn’t become more risky than intended.

You can choose a date to rebalance, per­haps at the beginning of the year, when you receive your annual statements, or at the end of each quarter. With our clients we review each portfolio every quarter to see if rebalancing is needed. You should compare your current allo­cation to your target allocation. Any allocations off by a designat­ed percentage would require rebalancing.

Monitor Market Conditions

In addition you might want to rebalance due to changes in market conditions. For example we combine tactical portfolio moves with rebalancing. Say for example we decide to put 5% of foreign bonds into all clients’ portfolios because we believe the dollar is overvalued. We will rebalance the portfolio according to the client’s overall strategy taking the 5% from an investment with less potential. This brings other investments back to their desired allocation level while adding the new investment.

Be Tax Efficient

Of course you want to be tax efficient when doing the rebalancing. Too often I see new clients who have managed mutual fund portfolios at the large brokerage firms that are managed in a cookie cutter strategy not being very tax efficient. For example say you have 3 brokerage accounts, your taxable joint account, your IRA and your spouse’s IRA. The typical broker wrap account would put the exact same mix of investments in each account and their automated system would generate the same rebalancing (buys/sales) in each account at the same time.

To save on taxes the investments that are rebalanced more frequently should be placed in your IRAs where the gains are tax deferred and the taxable joint account should hold the more strategic core investments. Over the years you can save significant taxes by intelligent placement of investments and disciplined rebalancing.

Maintain Your Asset Correlations

Another advantage of rebalancing is to maintain your portfolio’s overall investment correlations. Correlation is a statistical measure of how one asset class (type of investment) performs in relation to another asset class. Assets that are not highly correlated can help reduce the volatility in a portfolio. Thus, the lower the correlation between assets, the less variation you should tolerate. Being off tar­get will have a greater impact on your portfolio when the variation is between low correlation assets.

We at Ray Mignone & Associates, Inc. believe if you establish a good disciplined investment strategy with regular rebalancing you too will enjoy better performance from your investments.