February 7, 2023
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Harvesting your gains and staying on target


John Corby

By John Corby

One of the most important decisions confronting an investor is how much to allocate between the major asset classes: stocks, bonds, alternatives (which can include real estate and commodities) and cash.

Certain asset classes have inherently higher levels of risk, so how much to assign to each will depend on the tolerance each investor has for risk.
While risk is a consideration impacting asset allocation, investor goals are just as important. Asset allocation for the newly hired millennial should be quite different than the program for a just retired golden-ager.

Not all asset classes go up or down at the same time or at the same pace. In a well-designed portfolio structured to benefit from diversification, they’re not supposed to. As one asset class grows faster than another, it will become a greater percentage of the portfolio.

The result is a larger percentage in a riskier asset class, in this example stocks, which may carry more risk than the investor is willing to tolerate given his or her situation.

The portfolio is now more susceptible to the potentially higher volatility of equity returns compared to fixed income or cash. The investor may also want 5 percent in cash either out of preference or necessity. The portfolio has become unbalanced from the investor’s original plan and the risk level originally intended has changed, generally not for the better. The result is what is known as “drifting” asset allocation.

Rebalancing the portfolio back to its original targets involves selling areas which have performed well and buying stocks, bonds or alternatives that have not performed as well as the most successful asset class. Tax considerations can complicate the rebalancing exercise as investors should seek to avoid incurring taxes on realized gains. But there are other areas that can be looked at to mitigate the tax impact rebalancing may create, including using municipal bonds in the fixed income component, realizing losses in other areas of the portfolio to offset gains, and other solutions a financial adviser may suggest.

Rebalancing should not be limited to only the major asset classes; rebalancing the stock portion to a benchmark like the S&P 500 index can help minimize portfolio risk. In late 1990s, for example, when tech stocks were soaring and grew to nearly 50 percent of the index, investors could have found their allocation to tech stocks at higher levels, even approaching 60 percent of their equity portfolio.

It did not end well for these stocks. Investors endured the “Tech Wreck” of the early 2000s and suffered significant capital destruction in their portfolios. A review of their portfolio allocations and careful rebalancing that cut back overextended industry and sector weightings could have saved many investors from the considerable grief drifting asset allocation created.

The frequency of rebalancing is important as well. Once every five years is too long, but once a month is too often. Periodically — perhaps once or twice a year — adjusting the portfolio to reduce higher weightings caused by market outperformance and re-deploying assets into areas that have underperformed can help preserve profits earned.

Rebalancing back to original target allocations also helps to reduce and control the amount of risk in the portfolio.

Whether it’s a broad asset class like equities, a sector weighting like financials, or even an individual stock, too much of a good thing can end up being detrimental to the health of your portfolio.

Harvest the gains of strong performance and you will most likely see better long-term performance with less risk, something all investors can appreciate.

• John Corby is regional director of investments at HighMark Capital Management based in Santa Barbara.