Behavioral Approach to Portfolio Rebalancing

One of the key distinctions between traditional mean-variance asset allocation and behavioral theory is how risk is defined. Modern portfolio theory (MPT) defines risk as the variance around the mean return, while behavioral theory suggests that individuals view risk in terms of not meeting an important financial goal.

 

 

 

 

 

 

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Behavioral Approach to Portfolio Rebalancing

Behavioral Approach to Portfolio Rebalancing

A Behavioral Approach to Portfolio Rebalancing

One of the key distinctions between traditional mean-variance asset allocation and behavioral theory is how risk is defined. Modern portfolio theory (MPT) defines risk as the variance around the mean return, while behavioral theory suggests that individuals view risk in terms of not meeting an important financial goal.

In previous posts, we’ve explored this topic in great detail in previous posts, like Millennial Investment Attitudes, Behavioral Finance and Monkeys in Suits.

In this post, we’ll discuss the behavioral investment perspective on the annual portfolio rebalancing exercise.

Portfolio Rebalancing is No Longer an Automatic Reset

The conventional rebalancing approach is to reset the overall portfolio back to its original allocation on a regular, periodic basis. Thus, if varying asset class performance results in a drift away from a portfolio’s strategic allocation, a financial advisor will sell the over-weighted asset class and buy the under-weighted asset class to bring the portfolio back to its starting allocation.

When risk, however, is defined in terms of goal attainment—and is categorized in essential needs (minimum lifestyle requirements), wants (nice-to-haves) and aspirational (stretch goals) buckets—rebalancing a portfolio may take on a completely different feel.

Consider the example of a client who is 55 years old and looking to retire in 12 years. He has an essential retirement income goal of $75,000 per year. Based on future Social Security benefits and the current balance in his “essential” mental account, primarily comprised of bonds, he has a high confidence of meeting that retirement income goal. For more aspirational goals, he is much more heavily weighted toward stocks in order to improve the probability of attaining those goals.

Let’s now assume that stocks have substantially outperformed bonds in the year just ended. Under a mean-variance approach, a rebalancing would be automatic. However, using a behavioral approach, no rebalancing may be required. Because bonds performed in line with expectations, the probability of achieving the essential retirement income goal remains intact, while the outperformance of stocks has increased the probability of reaching the aspirational goals.

Rather than invoking a rules-based, automatic rebalancing of the portfolio, behavioral rebalancing instead begins with a client discussion to determine whether he prefers to increase the confidence level of the essential goal by shifting some portion of the increase in the stock portfolio to bonds, or to maintain the heightened equity exposure to potentially increase the odds of reaching his aspirational goals.

As this hypothetical example suggests, the behavioral approach represents an opportunity for investment professionals to have richer and more nuanced conversations with clients that may lead to better long-term outcomes and create sharp value distinctions with automated robo-advisor platforms.

See referenced disclosure (2)and (3) at http://blog.americanportfolios.com/disclosures/ 

About The Author

Cliff Walsh, CFA

 

Vice President of Asset Management 
631.439.4600 ext. 277 

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