The market turbulence of the last two years has challenged even the wisest and most experienced of investors. The difficult environment has delivered suboptimal returns revealing the susceptibility of portfolios while leaving no asset class unscathed. On the fixed income side a major challenge has been the shift from the previously high interest rate environment investors enjoyed to the current low interest rate environment. The most recent Treasury Bill Auction (held on Wednesday, June 16, 2010) produced an average yield of 9.26 per cent for the 180-day T-Bill – a stark shift from the highs of more than 24 per cent seen eighteen months ago. On the equity side the limitations of diversification and buy-and-hold strategies were also exposed.

With a constantly changing environment, the consequences of inaction are profound. Apart from losing the window of opportunity to further mitigate risk or re-align ones portfolio to increase its earnings based on the new dynamics of the market, one will also lose sleep at night, being kept awake, not only by the annoying buzz of mosquitoes but also by distressing thoughts of “what should I do?”, “should I have?” or “is it too late?”. To remedy this, Stocks & Securities Ltd’s advice is to deploy the regimented procedure of rebalancing your portfolio.

Re-balancing a portfolio is the procedure of adjusting the asset classes in the portfolio following a significant change, such as a new interest rate regime or a move from a bear to a bull market to ensure the goals of the investor are maintained in compliance with his/her risk tolerance. Simply stated, it is monitoring and taking the appropriate action on a portfolio when it no longer conforms to your plan. Two scenarios will be used to explain the benefits of re-balancing. One example uses an aggressive growth portfolio dampened by a declining economy. The other looks at the threat that growth in a riskier asset class may have on a moderate portfolio.

For the growth portfolio (We’ll use a starting total portfolio value of $100,000 so the calculations are easier and the dollars and percentages match). Given the risk tolerance, time horizon and financial goals the portfolio can be configured as 70 per cent stocks, 20 per cent repurchase agreements (repos) and 10 per cent cash.

After a year, the economy hits a bump and before the investor knows it, his/her stocks decline by 25 per cent, after-tax repos are earning three per cent, cash one per cent, and the portfolio now looks like this $83,200.

The investor will re-balance his/her portfolio and shift funds from the low interest bearing repo and cash into his/her stock portfolio to re-gain the original asset class allocation. For the aggressive individual the low interest rates will provide an incentive to invest in stocks. He/she may average down and purchase more of the stocks in his/her existing portfolio or opt to purchase new shares. If he/she does nothing a larger proportion of his/her portfolio (25 per cent as opposed to 20 per cent) will remain in low interest instruments and hinder his/her growth potential. By re-balancing his/her portfolio he/she accesses the opportunity for optimal portfolio returns.

For the moderate portfolio given the risk tolerance, time horizon and financial goals the portfolio can be configured with 40 per cent stocks, 40 per cent repos and 20 per cent cash. A scenario could occur where some of the investor’s stocks react positively to earnings reports and the portfolio now looks like this:

o Stocks (54%) -$72,000

o Repos (30%) – $40,400

o Cash (16%) – $20,200

o Total (100%) -$132,600

Great, what’s the problem? The portfolio is up $32,600 — isn’t that wonderful?’

Of course, it’s wonderful, however the problem is that the portfolio moved the investor away from his/her ideal asset allocation and possibly exposed him/her to more risk than is acceptable, for this moderate portfolio. This is where the moderate investor will take action and re-balance the portfolio back to the original allocation.

The portfolio owner can do this in several ways. First, he/she may sell some of his stock that had the recent appreciation and invest the profits in repos or fixed income instruments until the original allocation is achieved. Alternately, the investor could look at his/her stock holdings and sell any underperformers to generate the cash to invest in the repos. The third option would be to invest new money into the portfolio in repos and cash portion to bring those percentages up to the appropriate levels.

It would be tempting to leave the portfolio alone, however the purpose of establishing an allocation is to achieve the optimal return given each investor’s unique level of risk. Doing nothing disregards that premise and exposes the investor to unacceptable levels of risk.

However, it should be noted that following a significant change in asset allocation, investors should not rebalance their portfolios in isolation. Instead, they should revisit their original goals to see if they are being met. For example, if the stocks in the investor’s portfolio advance substantially, it does not mean that he/she should sell the stocks or re-balance immediately. Investors should ask themselves – “what is the earnings outlook or growth prospects for the Company”, “what was my original goal or target price when I purchased this equity?” and “has this recent stock rally comprised my risk tolerance?”.

Portfolio rebalancing is a critical aspect of investing. Investors should evaluate their portfolios at regular intervals and re-balance when necessary, especially during these challenging times, so that life appreciates.

Deon McLennon is an Investment Analyst at Stocks & Securities Ltd. You can contact him at dmclennon@sslinvest.com.