Real Estate & Retail

BULLS & BEARS: Rebalancing a portfolio requires careful thought

February 28, 2005

To finish the examination of asset allocation practices in the investment industry, consider the strategy called "portfolio rebalancing."

To refresh the understanding of asset allocation, think of an investment portfolio as being depicted by a pie chart. The various slices of the pie represent the percentage of the portfolio (money) an investor has allocated to each asset class. Examples of asset classes include largecompany stocks, small companies, international stocks, real estate investment trusts and fixed-income instruments.

An adviser may recommend a portfolio that, for example, has 30 percent in largecompany stocks, 25 percent in small-company stocks, 10 percent in international stocks, 5 percent in emerging markets, 5 percent in REITs, and 25 percent in bonds.

Over a length of time, these slices of the pie will typically experience different investment returns. For instance, maybe large-company stocks have appreciated to become 35 percent of the portfolio and international stocks have declined to 5 percent of overall assets. Rebalancing the portfolio would require selling 5 percent of the large-company slice and reinvesting the proceeds into international stocks.

Proponents of portfolio rebalancing claim this strategy essentially forces a discipline of "selling high and buying low."

While some of the principles involved in rebalancing can keep a portfolio on an even keel, there are some negatives associated with rebalancing. First, some rebalancing programs are too "mechanical" and shortterm oriented. We have seen situations where, at the end of each quarter, a computer-generated report spits out the asset classes to buy and sell to bring the investor's pie chart back into balance. The problem here is that there is no consideration to the investment fundamentals of the particular asset classes since a computer does not think.

Consider the situation we described in a previous column in which I noted that over the past five years, small-company stocks have far outperformed large-company stocks. If an investor had rebalanced his portfolio each quarter, he would have constantly reduced his exposure to an asset class that performed well, small stocks, and reinvested more money into underperforming large-company stocks. By regularly rebalancing his portfolio, the investor would have considerably less money today than if he had just left the asset allocation of his portfolio untouched.

Advocates claim rebalancing prevents a situation in which one asset class comes to dominate a portfolio. Yet, why should one sell an asset class or an individual security that has excellent prospects? Warren Buffet addressed this issue in his 1996 annual letter to Berkshire Hathaway shareholders: "To suggest that this investor should sell off portions of his most successful investments simply because they have come to dominate his portfolio is akin to suggesting that the [Chicago] Bulls trade Michael Jordan because he has become too important to the team."

In the end, we would shy away from rebalancing programs that shift assets like clockwork based on an arbitrary calendar date. Purchase and sale decisions made without regard to investment fundamentals are suspect. We realize that some of these ideas run counter to the mainstream investment dogma. Our purpose is to challenge investors to give rational thought as to how they go about building their net worth.



Skarbeck is managing partner of Indianapolis-based Aldebaran Capital LLC, a money-management firm. Views expressed are his own. He can be reached at 818-7827 or ken@aldebarancapital.com.
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