by WWM | Oct 16, 2019 | Portfolio Review
Investors should periodically review their investment portfolios. Based on the review, rebalancing may be necessary.
Factors that may dictate rebalancing include: individual holding performance causing misalignment with target asset allocation; material events causing a revised target asset allocation and need to rebalance to new mix; underperformance of individual holdings against peers or designated benchmarks.
How to review and when to rebalance are relatively straightforward.
But a common question is: “When? When should I review my portfolio?”
Material Event
A good idea is to review your portfolio whenever a material event occurs in your life.
That could be a market related event. The crash post 9-11. A war breaking out. A clear trend in interest rates or inflation.
If you own individual, non-diversified investments, such as stocks, events that impact the specific companies. Perhaps Apple has come up with their next iPod or iPhone concept. A revolutionary product that will change the marketplace. Or perhaps Tesla car batteries easily catch fire, resulting in major class action lawsuits.
A material event may also be personal. Marriage. A new baby. An inheritance. Job loss. These events may affect your investor profile, necessitating a change in your target asset allocation and investments.
In any of the above examples, probably not prudent to wait 8 months for your normal, annual review before assessing their potential impact on your portfolio and investment strategy.
Portfolio Risk
Not quite a “when”, but more of a “how often” issue. Though the two are definitely linked.
Many experts recommend annual reviews. In general, they are probably correct. But that is too simple a statement.
It may be wise to review a portfolio annually. But the periodicity should reflect the portfolio’s risk not the calendar.
If you invest in a basket of well-diversified, low-cost, index funds, an annual review should be sufficient. Subject to changes in material events as discussed above.
If you invest solely in small to mid-cap companies, you may want to keep a closer eye on holdings. Maybe quarterly or semi-annually. If your portfolio is made up entirely of stock options, you will want to monitor on a daily or weekly basis.
The higher the volatility (i.e., risk) of a portfolio, the shorter the time periods to review.
Investor Risk Tolerance
Similar with investors and their peace of mind.
A very risk averse investor probably cannot sit back and review on an annual basis. Regardless of what is in the portfolio. And it will likely be a relatively low risk portfolio, given the investor’s risk tolerance. This investor may want to check the portfolio weekly or monthly, even if annual may be reasonable.
Okay, the “When?”
We will assume an annual review. Semi-annual, quarterly, or even monthly are simply pieces of that pie.
Year End Review
The obvious date to review a portfolio is as of December 31. You get your year end data and review in January.
Very common. The date is intuitive. You can access lots of information, such as year end financial statements, tax information, fund data at year end, etc.
However, there are a few downsides to using December 31.
December 31 data may be a bit skewed. Stock prices may reflect tax based selling more than actual performance. Companies with December 31 year ends may speed up revenue recognition (or even increase losses) to make their annual results look strong (or clear the decks for the next fiscal year). Funds may engage in a little “window dressing” to adjust for style drift or underperforming assets they owned during the year.
What you see in December 31 data, may not always be the best measure of an investment.
Year End Costs
Another negative aspect of December 31 reviews is that most investors do them.
If you rely on a financial advisor to assist in the review, January and February will be an advisor’s busiest time of year. That may mean increased fees as demand will be high. It may also mean less attention to you.
Non-December 31 Review Date
Why not choose a non-December 31 review date?
I might choose June 30 or September 30 instead. You can also consider March 31. However, for many advisors, April is extremely busy with tax season. And then many advisors want to vacation in May, post tax. But if you are willing to wait until mid-May for a March 31 effective date, that would also work.
For most public companies or funds, these are normally quarter-end periods. There may be better or more information available at a quarter end versus a regular month end.
There may be less distortion in companies and fund results than at year end.
Your advisor may have excess available time in non-peak months. This may mean lower fees and greater attention. And, I can assure you, a grateful advisor for shifting the work load from peak demand into a traditionally light period.
Another useful feature of reviewing in July or October, is that it helps set up planning for the coming year end. Hard to discuss prudent pre-year end moves in January of the next year. But if you are considering tax planning or how portfolio changes may impact your end positions, better to consider them before year end. When there is still time to act.
by WWM | Oct 9, 2019 | Portfolio Rebalance
In How to Rebalance a Portfolio, we reviewed how you can either “divest and immediately reallocate”, or simply “reallocate future acquisitions”, as easy ways to rebalance back to your target asset allocation.
By divesting, you can quickly shift back to your target. By reallocating future investments, it may take substantial time.
However, divesting can generate capital gains taxes payable from selling outperforming assets. Taxes are a substantial drag on growth. The longer you keep wealth in your possession, the better your compound returns. You should try to minimize paying out taxes early on and let the entire money work for you as long as is possible.
Note that if you hold all your investments in tax-deferred accounts, this is not an issue.
For example, you have $100,000, earning 8% annually for 40 years, compounding once annually at year end. If residing in a tax-efficient investment account, it will grow to $2,172,452. If held in a regular account, you must pay tax on the yearly income. At a 35% tax rate, your capital now only grows to $759,678. Quite the incentive to utilize tax-efficient accounts.
Regardless of the potential tax hit, there may be times when it is prudent to consider selling and reallocating.
Non-Diversified Portfolio
Many investors maintain poorly diversified portfolios. As a result, it may make some sense to divest outperforming assets rather than try to simply adjust future investments.
Amongst other things, a well-diversified portfolio is one in which no individual investment has substantial impact on the portfolio as a whole. But many investors tend to have one or two stocks that dominate the overall portfolio.
For example, you and your brother own shares of Apple Inc. (AAPL).
AAPL is one of 20 stocks in your brother’s portfolio and accounts for about 5% of the equity component of his assets. That suggests that the portfolio may be diversified (other factors need to be reviewed before a conclusion can be reached).
You also own 20 stocks, but AAPL is 40% of your holdings. If the AAPL share price increases or decreases by 20%, the impact on your portfolio is significantly more than on his. Your portfolio is not well diversified (regardless of other factors).
This can have a few ramifications.
One Stock May Dominate
If AAPL increases quickly in price versus other holdings, you may find that it has become 50% or more of your portfolio.
This is the “too many eggs in one basket” concern. Where nonsystematic risk factors have substantial influence.
In contrast, an increase in AAPL share price will have less impact on your brother’s portfolio.
And, if the share price falls, your entire portfolio suffers based on one holding.
As to what constitutes “too many eggs”, there are many variables that determine proper diversification.
I would suggest though that no single asset (note that diversified investments such as funds are excluded) should make up more than 20% of one’s portfolio. And, in most cases, the percentage should be much, much less.
Abnormal Returns
Perhaps you own shares in 5 different companies. The benchmark market index returns 20% for the year. 4 of your 5 shares return between 10 and 15%, Yet one company has increased by 200% during the year.
As above, you may find that this one company now dominates your portfolio.
Also, the extreme performance of the one stock may mask the relative underperformance of the others.
But there is another potential issue.
Perhaps there is a reason for the company’s shares to appreciate this much. Maybe they developed an innovative product, discovered a huge reserve of natural resources, etc. The increase, and future potential, may be justified.
Or maybe the company has been over-hyped and is due for a correction in price.
Depending on your analysis and conclusions, you may wish to take some profits in case the stock has become overheated and the share price falls.
There are a variety of ways to trim your holdings in a single company.
You could sell everything and realize a large profit. In our example, 200% over one year before taxes.
Or if you think there is further upside, but are not certain, you could sell a portion of your holdings.
Perhaps you bought 1000 shares at $10 per share. After one year, the share price has climbed 200% to $30. If you sold 334 shares, you would have completely recovered your initial investment. You could hold the remaining 666 shares forever, knowing that they are “free”.
Or, if you are more risk averse, you could sell a higher percentage. By selling 500 shares at $30, you would realize $15,000 before tax. A 50% gross return on your initial investment. You now have less for future appreciation, but a 50% realized gross return and 500 “free” shares remaining is not too bad.
Investment Bubble
A single asset, market, or market segment that increases substantially in price might be prime for an investment bubble.
An investment bubble may be foreshadowed by abnormal returns in an asset or group of assets.
Look at the dot.com investment bubble and its crash in 2000. Your specific investments might have been solid companies, but they would have been caught up in the panic selling. The same is true with U.S. housing prices during the last decade. Many excellent houses sold at discount prices simply because the market as a whole was in difficulty.
As is said, “an ebbing tide, lowers all boats.” True, to a greater or lesser extent, with stocks in market crashes.
Even if you think your own individual investments are solid, to protect your portfolio it might be wise to sell a portion of your holdings in that asset or market segment.
Again, the percentage to sell depends on your analysis and conclusions, as well as your personal risk tolerance.
Summary
At times, it may be worthwhile to rebalance your portfolio by selling individual assets.
The costs of taxes payable might be worth the value you get by having one asset dominate your holdings and the resulting risks that come from having a weakly diversified portfolio.
by WWM | Oct 2, 2019 | Portfolio Rebalance
There are two easy ways to rebalance your investment portfolio.
While these methods work best for investments in diversified assets such as mutual and exchange traded funds, they can also be employed for non-diversified assets.
Perhaps your target asset allocation is 70% equities and 30% bonds, with an acceptable absolute target range of +/- 10%. After your latest portfolio review, you find that your actual asset allocation is 55% equities and 45% bonds.
You need to bring your portfolio back in line with your target allocation.
What do you do?
Divest and Reallocate the Proceeds
The obvious solution.
Sell 15% of your bond holdings and purchase equity investments with the proceeds.
Quick and simple. A big advantage.
The other potential advantage is that you are realizing profits. Perhaps an asset class (in our example, fixed income) goes on a lengthy bull market run and becomes overheated. By taking profits periodically, you can hedge against a downturn. Conversely, by reallocating to underperforming asset classes, you may achieve a boost when it begins to appreciate again.
Of course, you could be selling a great investment and moving the proceeds into a bad asset. Maybe selling Amazon and buying AIG over the last 15 years. Not a recipe for success. Which is why divest and reallocate may be better for well-diversified investments rather than individual stocks or bonds. And why reviewing non-diversified assets requires greater skill and care.
The real trouble with this method is that you usually incur costs on the rebalancing transactions.
Fund Commissions
One cost may be fund company commissions on purchases and redemptions.
If you own front or back-end load funds – do not invest in load funds unless you are convinced they are worth it in special circumstances – you may need to pay a sales fee to the mutual fund company. This can be quite onerous, especially for back-end load funds where you redeem relatively soon after acquisition.
Brokerage Fees
There may also be brokerage commissions paid.
Sometimes these are waived on no-transaction fee funds, but often there is a holding period required before you are safe. When buying no-transaction fee funds through your broker, read the fine print to see what, if any, charges you will incur on early redemptions.
Taxes Payable
The final hard cost associated with divesting and reallocating may be capital gains taxes payable.
In our example above, perhaps you initially invested USD 10,000 into equities (target 70% = USD 7000) and bonds (target 30% = USD 3000). During your review, the equities stayed flat at USD 7000 (actual 55%), but the bonds appreciated in value to USD 5800 (actual 45%).
If you sell enough bonds to revert to the target allocation of 30%, you have a profit of about USD 1064. Assuming all is capital, that capital gains are taxed at 20% (rates differ significantly between jurisdictions), and your investments are not in a tax-sheltered account, you owe the government USD 213 simply because you wanted to rebalance.
It may not sound like much, but your tax liability equates to 2% of your entire portfolio. That is an expensive fee to pay.
While divesting and reallocating may be the obvious solution, it may not be the best option outside of a tax-deferred investment account.
As an aside, always make use of tax deferred investment accounts if they are available.
Reallocate Future Acquisitions
Perhaps not as rapid a solution as divesting, but one that avoids immediate tax consequences.
If you have the investment capital on hand, you can purchase enough of the under-weighted asset to bring it back in line with the target allocation. But many investors do not have lump sums of cash on hand to invest in one transaction.
Fortunately, this method dovetails nicely for investors who utilize dollar cost averaging in accumulating assets.
In our example above, let us say that you invest USD 300 per month. Under your target allocation, you would allocate acquisitions at USD 210 to equities and USD 90 to bonds. Note though, in practice you will probably not invest exactly like this on a monthly basis. You need to adjust investing patterns based on amounts, periodicity, transaction costs, etc.
However, to bring yourself back in line with your master target allocation, you will have to alter your monthly split. You could reallocate future allocations to 100% equities until such time that your overall portfolio reverts to your target 70-30 ratio. At that point, you can go back to your original investment split.
In our example, the actual allocation shifted to USD 7000 equities (55%) and USD 5800 bonds (45%). If you allocate all USD 300 each month to equities, you could gradually get back to your target levels without triggering any tax liability. In this case, assuming that both the equities and bonds do not change in price, it would take about 24 months to reach your target allocation again.
Not the fastest method, but one that avoids taxes.
And no doubt, in 12 months at your next portfolio review, you will have to readjust the future allocations again.
Another plus is that by altering future purchase patterns until rebalanced, you buy the underperforming asset (hopefully) “on sale” and avoid a potentially overvalued asset. Again, assessing asset quality is part of the review process.
The potential drawback to this method is that you are not crystallizing profits. Yes, you are shifting future purchases to relative underperforming asset classes or subclasses. But if interest rates increase quickly, you may see your unrealized bond gains decrease or be lost entirely.
Summary
The advantage of divesting and reallocating is that it is a quick fix.
Another potential advantage is that you are realizing profits. As well as hopefully selling an overvalued asset and buying one that is “on sale”. Of course, perhaps you are selling a strong asset you should keep and shifting the profits into a dog. That is why this tends to work well with diversified investments and why proper portfolio reviews are important. But yes, always a psychological issue to sell winners and purchase perceived losers regardless of review research.
The big downside of divest and reallocate is that you may incur costs on the rebalancing, especially relating to capital gains taxation. But if your assets are held in tax efficient investment accounts, this is not really an issue.
Using future investment capital to adjust your asset allocation over time is a much slower process. How slow depends on your periodic contributions and the amount you need to adjust. While you will incur transaction costs on those future acquisitions, your total expenses relating to the readjustment will be less. Why? Because you are not disposing of profitable assets and triggering any tax liability on realized capital gains.
On the other hand, you are not locking in profits and immediately buying other “on sale” assets.
Given today’s relatively low transaction costs on buying and selling, as well as the extensive use of tax efficient investment accounts, divest and reallocate may be preferable. As well, investing in well-diversified assets reduces the risk of moving from a superior investment to a perennial cellar dweller.
However, costs can add up if you reallocate too often. So reallocating purchases over time in your normal buying periodicity may work better for you. Even when investing in a tax-deferred or tax-free account.
by WWM | Sep 25, 2019 | Portfolio Rebalance
The goal of portfolio rebalancing is to bring your actual asset allocation back in line with your target allocation.
Your target allocation should be based on your Investment Policy Statement (IPS). This reflects your personal circumstances, investment objectives, constraints, risk tolerance, etc.
Who you are as an investor.
When initiating your investment strategy, it is pretty simple to adhere to the target asset allocation. But over time, as certain assets perform well and others lag, your actual allocation will deviate from your target.
Additionally, as your personal situation changes, you may need to adjust your target asset allocation.
In either of these cases, you will need to rebalance your portfolio.
Today, a few thoughts on rebalancing in general.
Buy and Hold?
How can you buy and hold, yet rebalance? Is that not a contradiction?
To some extent, yes.
The longer you hold an asset, the less transaction costs you incur and the longer you defer paying tax on capital gains. Minimizing and delaying costs improves compound returns for your portfolio.
As well, selling an asset and reinvesting the proceeds in another investment may not guarantee improved results. Attempting to time markets or the peaks and valleys of individual assets may not achieve better performance.
So you want to try and hold your assets as long as is prudent.
But sometimes you will need to adjust your assets. Either to fix your asset allocation. Or possibly to sell poor investments.
Dump the Dogs
Hopefully you will not have too many under-performing investments that should be sold.
If you follow my investment strategy, you should not have many (any?) dogs.
There are two reasons for this.
One, I generally recommend investing in an asset class, or sub-class, as a whole. I tend not to recommend investing in individual, non-diversified assets.
If you wish to invest in Canadian equities an index mutual or exchange traded fund with broad exposure to the Canadian market should be your choice.
By investing in a diversified portfolio with multiple holdings that perform in line with a broad market, you should not have any individual under-performers.
Two, by conducting proper due diligence before investing your wealth in funds, you should acquire “best of breed” investments.
That should minimize problems with items such as tracking error and fund expenses which can impair net performance.
Of course, over time fund management and relative performance can change. So you need to always be sure that your investments rank in the top quartile (or better) of their category.
If you invest in non-diversified assets (e.g., individual equities or bonds) or actively managed funds, there is a higher probability that some of these investments will under-perform.
Minimize Costs
Each time you sell an asset, you incur costs.
Transaction costs on the sale and subsequent reinvestment in another asset.
Capital gains that are triggered on sales. By delaying divestment, you defer the potential tax liability.
Possible opportunity costs as well. For example, it is extremely difficult to time market or asset movements. If you divest an investment, perhaps its performance will improve and you will have missed out on the gains.
These costs negatively impact the ability to maximize your portfolio’s compound returns. So use care when selling investments to rebalance.
Use Ranges to Rebalancing
I suggest using ranges to rebalance.
For example, if your target equity allocation is 50%, do not rebalance unless your actual allocation is greater than 60% or less than 40%.
Using a range provides some flexibility for portfolio volatility.
If your target allocation is 50% equities and you rebalance at 52%, you may find that the change was due simply to general market volatility and not a long-term change, If this is the case, you may see your actual equity level fall back to 47% the following year and you may need to rebalance up again.
By using a range linked to the risk of the asset, it may reduce your rebalancing needs and related costs.
I usually like to link a range to the volatility (i.e., risk) of an investment. A relatively lower risk investment, such as a government short term bond fund, will have less general volatility than a small-cap equity fund. If you use the same ranges to rebalance, you may be rebalancing the equity fund simply due to standard volatility. Often, the higher the asset risk, the greater the range before rebalancing.
Frequency of Rebalancing
Always a tough question as to how often a portfolio should be rebalanced.
Rebalancing should be the result of the portfolio review process.
Portfolios should be reviewed a minimum of once per year. As with rebalancing ranges, for a portfolio with higher risk there should be a greater number of reviews each year. If you have a portfolio of stock options or African mining companies, you need to keep an eye on the markets and specific economic conditions more closely than in a broad based fund.
If your review process indicates that you need to make changes, then do so.
But make sure that your rebalancing ranges are adequate so that you are not constantly selling investments and purchasing new ones.
It is hard to pick a firm number as there are so many variables that impact a need to rebalance. But if you are adjusting your portfolio more than once a year (assuming you are primarily invested in index funds), you may want to consider the reasons why.
Next up, we will look at ways to rebalance one’s portfolio on a cost-effective basis.
by WWM | Sep 18, 2019 | Portfolio Review
What are the keys to a successful investment portfolio review?
Depending on your investment skills and experience, you can assess portfolios via a multitude of factors. But for most investors, there are some basics that should always be reviewed.
We have covered them in previous posts, but I shall provide a quick summary here.
Pre-Determined Benchmarks
You should always create benchmarks against which you will compare your portfolio composition and results.
Determine relevant benchmarks, using multiple benchmarks whenever possible, prior to actually building your portfolio. At the same time you determine your target asset allocation and investments. This will keep you honest when conducting your portfolio analysis on the actual allocations and performance over time.
As such, benchmarks should be based on your unique Investor Profile and the resulting target asset allocation.
Benchmarks can relate to many different areas. These include: common data or arbitrary numbers; relevant publicly available indices; actual peer and style category performance; planned target asset allocation. For better analysis, use combinations of these benchmarks that best fit your analytical needs.
Performance
Net performance drives wealth accumulation. So you want to make sure your portfolio does well relative to its benchmarks. But performance comes in many different forms.
Performance may be annualized or cover the holding period. A 100% return may sound great. But if it takes place over a 20 year holding period, the annual return may not be as nice as it appears.
Conversely, a 5% annual return may be nice if your peer group average was -10%.
Not all investment returns are the same. Understand the difference between: gross and net returns; realized and unrealized gains; base and local currency performance. Costs, fees, taxes, foreign exchange, and paper versus actual profits, will all greatly impact your analysis.
Always factor in inflation rates. A 100% return may seem wonderful, but not so much if you are living in a period of hyper-inflation. See 2019 in Venezuela as a sad example of this.
And always know what return data is being presented. Massaged financial information can lead you to incorrect decisions. For example, there may be a difference between mean and median returns. There may be further variances when factoring in time weighted versus dollar weighted returns.
Portfolio Composition
A key to any analysis is an apples to apples comparison. Especially relating to portfolio risk.
And equally applicable when investing in asset subclasses as risk can vary from the overall asset class risk-return profile.
You want your benchmark to reflect the composition of your portfolio, where the benchmark is an index, peer group member or average, or target allocation.
Reflect, not necessarily exactly mirror. Unless you are investing in the index itself.
You want your portfolio to reflect the benchmark in respect of expected return and risk.
If you use a risk-free rate (i.e., Treasury bills) as a benchmark for a portfolio made up of shares in unlisted small companies, the comparison becomes irrelevant. You are trying to compare a risk-less benchmark against a high risk portfolio. Any comparative data will make no sense, other than simply knowing your performance relative to a completely safe asset.
The same holds true comparing the Dow Jones 30 to the unlisted small cap stocks. Or to Argentinian or German companies. There are different return expectations and volatility between the groups. That makes comparisons difficult.
Asset Allocation
You want your portfolio’s asset allocation to reflect your target asset allocation.
And your chosen benchmarks should also reflect your target asset allocation.
If you have a simple target asset allocation of 70% U.S. equities and 30% U.S. bonds, both your benchmark and actual portfolio should reflect this. Perhaps your selected benchmarks should be the Standard & Poor’s 500 for equities and the Barclays Capital Aggregate Bond Index for the bonds. Weighted 70% and 30% respectively.
Material Variance
A material event is one that triggers action on your part.
For example, perhaps you are considering buying a car. Color, interior design, stereo system, horse power, etc., may all play a part in your decision making. They will have a cumulative effect on your choice. But individually, the car’s color or its stereo system probably will not be a deal breaker.
Instead, a sale price, low interest financing, warranty, consumer satisfaction surveys, etc., may play more important roles in your decision. If your potential vehicle is considered a lemon, you may decide to choose a different make. Or if you can get excellent financing terms, you may be swayed in your decision. Any one factor can make or break the purchase decision.
These latter factors are material events. The key points that affect decision making.
You need to identify the make or break points in your portfolio analysis. And these points are largely driven by who you are as an investor. Your risk tolerance, investment objectives, constraints, etc. Your investor profile.
These will obviously differ from individual to individual.
For example, some risk averse investors may not be comfortable with any negative portfolio returns. Others may accept short-term or minor losses, say no more than 10% of invested capital. And others may accept losses of 25%, 50%, or more before taking remedial measures.
While you want to ensure that your portfolio does not underperform, it can be a tricky process. It is a fine line between fine tuning a portfolio and in either waiting too long to make changes or adjusting too often.
A common material review point for investments in funds is peer review. If your fund is ranked in the bottom half of its peer group over (say) 3 years, it may be worth considering a change. Either it is selecting poor investments relative to other fund companies in the same asset category. Or it is extremely costly in fees and that is dragging down results. Either way, other investment options may be preferable.
We will consider when and how to rebalance a portfolio next week.