It’s been said the most important and difficult part of investing is to have a philosophy and stick to it. We’ve had a lot of conversations with clients about portfolio strategy as it relates to recent events and we want to clarify an aspect of our philosophy and value-add to you.

The recent volatility in the markets due to the coronavirus has many asking a simple question: What is being done with our portfolios with regard to both safety and opportunities? To answer, I want to give you some perspective on this topic. For overall portfolio management, it’s really a dual approach consisting of the following principles:

1. We recommend that you do not change the strategic allocation you developed in a forward- thinking planning process unless there have been significant changes to your personal financial circumstances. The heavy lifting was completed when we initially invested your portfolio based on our decades of research and due diligence to uncover your personal goals and risk profile. This, combined with an overwhelming amount of evidence that suggests trying to time the market can lead to less-than-desirable results.

2. Conversely, despite the seemingly passive stance indicated in point one, there is a lot of activity occurring on a daily basis within your underlying mutual funds (fund level) at the discretion of the fund managers we continually monitor. At the portfolio level, WorthPointe tracks the percentage allocation of all your allocations at generally two levels: stocks and bond ratio, and asset class ratio.

One opportunity generally available throughout the life of a portfolio but seemingly more acute during times of higher volatility is rebalancing. For our discussion and simplicity, we’ll stick to a discussion of the balance between stocks and bonds, with the understanding we manage a similar process at the asset class level.

Let’s start by way of example. Imagine a hypothetical $2 million portfolio allocated with 50% stocks and 50% bonds. You would therefore have $1 million in stocks and $1 million in bonds.

Now let’s say the stock market went down by 30% and the bonds held level. Your portfolio would now look like this:

As you can see, just by market movement, this hypothetical portfolio is out of balance from the original 50/50 desired target and is now only 41.2% stocks and 58.8% bonds due to the movement of the stock market. If you desired to rebalance the portfolio back to its original allocation, we would sell $150,000 of bonds and purchase $150,000 of stock to get the portfolio back to 50/50 represented in the following pie chart.

The overall value of the portfolio is down, but you have accomplished two things: 1) the portfolio is back to its intended allocation, and 2) you had the benefit of buying an asset class (stocks) that may be relatively down in price — selling high and buying low. Often, this happens during a time when other investors may be doing the opposite — selling low and buying high — which is not necessarily a recipe for success.

Another important thing to note is although we assumed a 30% drop in the stock market, the relative percentage allocation of stocks to bonds in our example allocation only dropped by 8.8% prior to rebalancing (50% to 41.2%). So, while many investors might think a significant drop in the stock market automatically necessitates rebalancing, the math tells us this may not necessarily be the case. Why? Because even after a significant drop in the stock market, the stock allocation might still be within the bounds set around your target. (A further explanation of targets and boundaries is below.)

The central questions arising from these principles are:

1. How does WorthPointe manage this process and add value?
2. Does the recent downturn in the market necessitate rebalancing in my portfolio?

You’ll find varying ideas on when to rebalance, some based on time, some based strictly on targets and percentage drift. Here’s our philosophy.

1. How does WorthPointe manage this process and add value?

Simply put, we assign a target percentage of stocks and bonds in our systems for each and every portfolio we manage. This overall target was agreed upon using the Investment Policy Statement (IPS) we personalized for you based on your risk and return analysis and other factors in our planning. In the example above, our IPS allocation is 50% stocks and 50% bonds.

To monitor the portfolio over time, we not only put a direct target on the amount of stock we want (50% in our example), but also allocate boundaries within which the stock allocation can drift. If the boundaries are too tight, the portfolio ends up trading too much; if they are too wide, the portfolio allocations can drift beyond the point of intended purpose. Setting the boundaries at the correct distance around the target to accommodate these two principles is important.

The diagram below is a visual example of our hypothetical 50/50 portfolio, starting at 50% stock. Due to an eventual decline in the value of stocks, the percentage of stocks relative to bonds drifts down. Once the relative stock percentage drifts below the lower boundary (red dot), we now have a rebalancing opportunity. In this case, the portfolio is rebalanced and the stock percentage goes back to its center-line target and then continues to be monitored as it drifts over time within the boundaries.

2. Does the recent downturn in the market necessitate rebalancing in my portfolio?

Not necessarily. Many factors play into this and we’ve described a couple below — the second of which is probably most important in our current environment.

a. We are able to use cash flows into and out of a portfolio to rebalance. In our example, if the stock percentage was below where we want it to be and there was a cash contribution to the portfolio (including dividends and interest), we would in most cases buy into stock to help rebalance, affecting a natural rebalance in the process. This same process is used for cash distributions out of the portfolio, in reverse.

b. The higher the volatility of the stock market, the higher the risk that you could add a lot of unneeded activity and fees if you rebalance too soon. This is easily illustrated. Imagine you had a significant drop in the stock market on day one and the portfolio was rebalanced. Then on day two you have a significant gain in the stock market and again you rebalance. Instead, if you had just done nothing through that two-day cycle, the portfolio might have ended up at about the same place without all that added activity and potential fees. Importantly, we have seen this type of volatility in the past weeks.

Let’s look at the ending results in this example scenario by way of a visual.

Assumptions:
> Day 1: Start at a 50/50 portfolio
> Day 2: 30% drop in stocks, bonds hold level
> Day 3: 30% increase in stocks, bonds hold level

Where do we end up?

As can be seen, we end up very close to where we started, so even with these significant swings in the stock market, we would most likely not initiate a rebalance on the portfolio. Investors who were too quick on the trigger might have rebalanced on day 2 and day 3, ending up close to the same outcome had they let things be, but with a lot of wasted effort.

A final note on the current state of our client portfolios. Prior to the recent stock market downturn, many were hovering around the higher boundaries of our targets due to the recent market increases, so many stock allocations had plenty of room to drift toward their lower boundary prior to initiating any rebalancing. In reality, we have seen less than 10% of our portfolios needing rebalancing year-to-date.

In summary, remember there is an abundance of research on rebalancing strategies, much of it conflicting. We believe rebalancing is not just a science, but also an art that relies on experience and expertise gained over decades of managing client portfolios with comprehensive systems. We will continue to monitor and manage your portfolio for both safety and opportunities not only through the current crisis, but in the coming decades.

All investments involve risk, including the possible loss of principal. Different portfolios will have different objectives and risk profiles. The information contained herein is for illustrative purposes only and does not reflect actual results or an actual portfolio. Economic factors, market conditions and investment strategies will affect the performance of any portfolio and there can be no assurance that a portfolio will match or outperform any particular index or benchmark.