…excerpt from Mo Lidsky’s latest book, Partners in Preservation

The simplest way to understand the progression from monitoring the portfolio (ensuring investment managers are doing what they said they were going to do and addressing issues as they surface) to rebalancing is with analogous to the annual checkup with your doctor. There is hardly anything more basic than the need for an annual checkup where one could see if everything is status quo or if there has been an unexpected deviation (e.g., blood sugar levels too low, cholesterol too high, unusual weight gain or loss). These checkups provide the patient with the opportunity to spot or monitor any problem or deviation from the norm and correct – i.e. rebalance – it.

Those who skip a year or two are often urged (or perhaps dragged) by their loved ones to make that checkup. Yet, notwithstanding these good habits with our physical health, most investors have not adopted them in their financial health. It is astonishing that investors can go such long periods of time, possibly even a lifetime, without ever considering a checkup for their portfolio. In 1986, there was a study conducted on the investment habits of the 850,000 individuals employed in higher education. The remarkable thing is that over their entire investment lifetime, more than 72 percent of these individuals never made a single change to their asset allocation mix, and fewer than 2.5 percent made a change in any given year. Most simply held on to the same funds they bought on day one without making any changes whatsoever. This is consistent with another study demonstrating that nearly 80 percent of the 1.2 million 401(k) investors with retirement accounts in the USA didn’t move one penny from one fund to another fund in a two-year period where markets rallied over 40 percent.

Investors can be very pleased or dissatisfied with their investments, and they may even be aware of problems, but most rarely go through the efforts of a portfolio checkup or employ the crucial discipline of portfolio rebalancing, which should be done once a year. Portfolio rebalancing shifts the portfolio to adhere to the asset allocation bands outlined in their Investment Policy Statement. For example, when equities take a tumble and fixed income becomes a larger portion of the portfolio, rebalancing may include selling off some of the more expensive fixed income investments and purchase cheaper equities.

Benjamin Graham, the father of value investing, said, “The essence of investment management is the management of risks, not the management of returns.” Unfortunately, investors seldom spend sufficient time determining where heightened risk lies, what can go wrong, where the portfolio is overconcentrated, and what they can do about it. At the heart of this neglect to manage risk is investors’ complacency, the very condition rebalancing aims to cure.

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