Recent share market gains have given many balanced portfolios a higher equities tilt…

Share markets around the world have hit record highs this year, propelling the equity valuations of many investment portfolios.

A combination of strong corporate earnings results and forecasts, and expectations that economic conditions will continue to improve over 2024, have fuelled the share prices of many companies.

That’s positive news overall, but it also means that diversified investors wanting to maintain specific asset weightings in their portfolio based on their investment risk appetite may need to make some adjustments.

Not doing so could see their portfolio drift away from their intended asset allocation strategy and expose them to a higher level of investment risk than they had planned.

The great Australian drift

The Australian share market, measured by the S&P/ASX 300 Total Return Index, has risen by around 70% since the March 2020 COVID crash.

To get a good perspective on what portfolio drift can do over time, let’s look at how a portfolio with a 60% allocation to Australian shares and a 40% allocation to Australian bonds would have drifted since March 2020 if an investor had made no adjustments along the way.

By now, purely as a result of the share market gains over the last four years, the value of the equity component of that same portfolio would have risen to almost 75%.

That represents a sizeable 15% increase to the investor’s risk profile and would have turned their asset allocation from being almost balanced towards a higher-growth tilt.

But such an outcome could have been very easily avoided through the execution of a portfolio rebalancing strategy to ensure it remained broadly aligned to the intended 60:40 weightings.

Two ways to realign your portfolio

Investors basically have a couple of options to keep their portfolio aligned to their risk profile and intended strategy.

Using the above example, an investor could sell down 15% of their allocation to shares and then use those proceeds to top up their allocation to bonds to bring their portfolio back to a 60:40 weighting.

Or they could maintain their shares exposure and top up their investment in bonds to achieve the same 60:40 weighting outcome.

But the mark of a good portfolio management strategy is to ensure one’s intended investment weightings don’t end up moving way out of alignment.

There is no one-size fits all strategy for rebalancing a portfolio. Professional portfolio managers rebalance product portfolios on a constant basis, whenever they move out of alignment with their intended strategy, based on set tolerance levels.

However, there’s a key difference between how a portfolio manager can readily rebalance a diversified portfolio versus the average retail investor.

That is, rather than having to sell assets to keep a portfolio aligned, portfolio managers use cash inflows to buy underweight assets whenever they can to keep a portfolio within its target asset tolerance levels. This minimises turnover and reduces the need to realise capital gains in the fund.

By contrast, retail investors need to sell and buy portfolio assets to ensure their portfolio remains aligned. In doing so they face triggering a capital gains tax event.

Investors also don’t have the benefit of daily cash flows into their portfolio to top up underweight assets.

Have a disciplined approach to rebalancing

The key to rebalancing is to adopt a disciplined approach that has been well-researched to deliver optimal outcomes.

An optimal strategy must balance the requirement to stay close to target allocations, with the competing headwinds of transaction costs (the more frequent or larger the rebalancing transactions, the greater the transaction costs) and tax considerations.

In addition, more sophisticated investment portfolios spread across multiple asset classes have a higher level of operational complexity to keep their intended asset weightings aligned.

At the same time, when considering rebalancing a portfolio, investors should take into account that short-term market fluctuations may actually assist in bringing a portfolio’s allocations back to the target weighting.

As such, the level of trading required to bring allocations closer to target weighting may actually be minimal or not even required.

It can make sense to have a strategy to make ongoing, small portfolio adjustments if a diversified portfolio deviates from its target allocations by 5% or more.

Whether you do it yourself or leave it to professional portfolio managers, there are clear benefits in avoiding portfolio drift as much as possible.

Fundamentally, investors who rebalance their asset mix in a disciplined way are much more likely to remain aligned to their chosen investment strategy, based around their tolerance for risk.

An iteration of this article was published in the Australian Financial Review.

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