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June 07 newsletter

Your investment portfolio may include allocations to the some or all of the investment asset classes: cash, fixed interest, Australian shares, international shares, absolute return strategies, and currency considerations. This allocation will be based on recommended strategic or tactical directions, and should be reviewed at least annually.

The first part of such a review will consider any changes to the overall allocation: should more or less be invested in international shares, for example.

However, it is the second part of this allocation review that this newsletter focuses on – ensuring that your portfolio is rebalanced.

An example

Let’s take a simple example, of a 2-asset investment portfolio of shares and fixed interest, in which $50,000 of a $100,000 investment portfolio is invested in each asset class. That is, at the beginning of the year, the recommended strategic allocation is 50% in each of the assets.

Now let’s assume that, at the end of the year, the shares, after enjoying a stellar 20% increase over the year, are now worth $60,000. Let’s also assume that fixed interest investments have not moved and are still worth $50,000 at the year’s end. The total investment portfolio is now worth $110,000.

Let’s assume that the recommended asset allocation is still 50% in each of the two asset classes. The portfolio is now imbalanced, with shares representing 55% of the portfolio ($60/$110) and fixed interest 45%. The portfolio requires rebalancing, by selling $5,000 of shares and using those funds to buy $5,000 of fixed interest, so that both asset classes have $55,000 invested and again represent 50% each of the portfolio.

The issues

Now this is not as easy as it sounds. There are two issues. The first is that when buying and selling you incur transaction costs which decrease your investment return. Rebalancing when either adding new funds or cashing out some of the investments avoids this problem.

However, the more problematic issue is that you are selling the investment that made 20% in order to buy the investment that made nothing. It is counter-intuitive and therefore against natural human behavior. However, if investors had banked the 2-year 50% increase in the Dow Jones Industrial Average in 2000, they wouldn’t have gone on to lose that huge gain over the subsequent two years.

Random page of the month

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