Maintaining Balance

This past weekend, my wife and I decided to buy a trampoline, and after a few hours of tedious construction we finished, or so I thought. I knew that my backyard was sloped slightly, but it was clear that additional work was necessary for the trampoline to be level. So bright and early on Sunday morning, I went out with a pickaxe and began the arduous task of digging trenches in the yard so that the trampoline would be able to sit level. After many iterations of adjusting the legs by adding and removing dirt, it is now close enough to level that my kids can safely enjoy hours of jumping around.

Because the ground beneath the legs of the trampoline will shift over time, especially after I start jumping on it, I plan on measuring the trampoline periodically to ensure that it is still relatively level, and if necessary, make adjustments by adding or removing dirt on the legs that are out of balance. In doing this periodic review, I can take comfort knowing that myself or someone in my family will be less likely to have an accident.

In terms of our investments, investors can think of each asset class of their portfolio (US Stocks, International Stocks, Bonds, etc.) as different legs on a portfolio trampoline. Like my trampoline, RK allows a certain amount of movement in each asset class before we take action to make our portfolios “level” again. When one asset class grows too large relative to the portfolio, we will trim (sell), and if it shrinks too much, we will add to it (buy).  But rather than guess on the amount of movement we will allow before taking action, an Investment Policy Statement (IPS) establishes both the types of asset classes that we will own and the amount that we will let them shift before taking action. Unlike my trampoline, our investment portfolios can be reviewed every year, quarter, month, or week.

So how often should investors review their investment portfolio, and how much should they let them shift before readjusting?

A 2007 study published in the Journal of Financial Planning by Gobind Daryanani analyzed a diversified portfolio to determine what the optimal time horizon and tolerance bands investors should use when looking to rebalance. The results of the study are below.

A closer look at the table shows some interesting results. An approach that continually monitors and adjusts a portfolio daily with zero tolerance for movement will result in an overall performance drag of 2.44% versus if an investor just sat on their hands and let the portfolio run unimpeded. The sweet spot for the rebalance threshold and time horizon comes in at 20% with a time interval of 10, 5, or 1 trading days. In light of this research, RK has determined that a 20% rebalance threshold with a review period of 10 trading days is optimal. Using this approach was shown to add incremental return for the portfolio over the long-term while minimizing the effects of a higher turnover and unnecessary trading costs.

We can’t predict when or which “legs” of our portfolio will rise or fall, but we can control the amount that we allow them to move before taking any actions to rebalance the portfolio and how often we are reviewing it. This disciplined approach guards us against acting emotionally and making trading decisions based on how we feel the future will play out and will allow us to maintain our balance through times of market bounces.