You're doing it wrong: Annual portfolio rebalancing isn't enough

The annual ritual of changing clients' portfolio allocations for the new year no longer suffices when technology enables instant rebalancing, according to planners and other experts. 

As a time-honored staple of personal finance, yearly rebalancing routines set up clients' investments in line with their goals and a prudent course in their view and that of their financial advisor in response to the trends affecting stocks, bonds and other asset classes. Those macroeconomic forces exert themselves across all 12 months of the year, though. Despite the continued need for taking certain strategic actions toward the end of the year such as planning for required minimum distributions or tapping into practice management opportunities through regular client meetings in the fourth quarter, the potential tax-loss harvesting, higher investment yields and enduring value of professional advice display why it's important to be more nimble.

For example, the S&P 500 index fluctuated between going up by 6.5% in roughly the first four months of 2023, a 12% jump in the next three, a loss of 9.7% between late July and October and another 12% climb through the middle of December, noted Monica Dwyer, an advisor with West Chester, Ohio-based Harvest Financial Advisors. Those gains and declines took place after the historically bad returns for stocks and bonds in 2022.

"This year is a very good example of why it is important to rebalance accounts throughout the year, not just at the end of the year," Dwyer said in an email. "If you wait too long to rebalance, you run into a situation where you could lose a great deal in a particular market segment, and a good example of that is technology stocks in 2022. For many years we have been selling them off at high prices, but in 2022 we were purchasing them at lower prices."

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The need for much more frequent scrutiny of clients' portfolios for possible adjustments reflects shifts "in the advisor role and even the investor role," according to Jerry Michael, the president of Smartleaf, a company whose asset management unit provides automated rebalancing. Rather than simply asking advisors whether to buy shares in Tesla, these days clients should expect investment professionals to use tumbling security values to offset capital gains for tax purposes and avoid the "noise" that often causes similar portfolios' variations, he said.

"It's not because they don't know what to do, it's because they don't have enough hours in the day to do it for every client. We haven't invented some new technique," Michael said in an interview. The firm suggests advisors "manage every portfolio" as if they were only overseeing one of them "all day, basically eight hours a day," he added. "They wouldn't be rebalancing annually, they would be doing a better job."

Turnkey asset management platforms and other outsourced technology have altered how advisors view their clients' portfolios on a daily basis, according to Steve Oniya, a planner with Houston-based OM Investments.

"Yes it would be hard for an advisor to manually customize and rebalance several times in the years across tens of clients repeatedly. On the other hand, an advisor can hire a TAMP to automatically do that several times," Oniya said in an email. "Although rebalancing multiple times in a year can be greater returns/savings, the costs to do that versus the long-term holdings with the overall goals and values of a client could be marginal. Granted, every little bit adds up (compounding). It depends on the advisor's capacity and the costs clients and advisors are willing to incur."

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Some advisory practices have embraced software that alerts them when clients' portfolios need their attention.

"We have trading ranges set for each asset class in our portfolios," Dennis "DJ" Hunt of Orlando-based Moisand Fitzgerald Tamayo said in an email. "When the market action takes a given asset class out of that range, we are notified and move to rebalance that account."

Envestnet | Tamarac's software helps the Southfield, Michigan-based Center for Financial Planning pursue "opportunistic" and "cash flow" rebalancing, Director of Investments Angela Palacios noted in an email. The technology to "review client portfolios regularly for drift outside of asset allocation tolerances" enables the firm to pursue "higher potential returns and/or risk reduction if you are rebalancing closer to a peak or trough," Palacios said.

"Cash-flow rebalancing is another method we use regularly for accounts with cash moving into or out of the accounts," she said. "If a cash distribution is needed, the asset category or categories that are the most overweight will be what is sold to raise cash. If cash is flowing into the account, we will purchase the asset category or categories that are the most underweight. A potential benefit to rebalancing in this manner is tax efficiency. Rather than selling a position and taking a capital gain to deploy that money into an underweight asset class, using newly deposited cash can potentially help you avoid the sell transaction that may cause a gain if it is in a taxable account. Even those that may not be able to actively add to their portfolios could still utilize this rebalancing method by having dividends pay to cash in their portfolios. The cash from dividends can deploy into the most underweight area of the portfolio and rather than automatically reinvesting into the same position which may already be overweight."

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Allocating those often quarterly dividends payments gives advisors and their clients an "additional cash reservoir to go ahead and rebalance the portfolio a bit more strategically," said Jordan Naffa, the director of financial planning with Las Vegas-based Arista Wealth Management. With benefits such as maintaining the agreed-upon level of risk, sticking to long-term goals and tax-loss harvesting, regular rebalancing through the year has become "a fundamental component of services" offered by advisory practices, Naffa said in an interview.

"Clients perhaps can become very impulsive during market volatility," he said. "That just helps to curtail emotional decisions that are made."