Alexander Efros...'s  Instablog

While diversification has long been accepted as a valuable component of a risk-managed portfolio, another powerful mechanism which can be used to minimize risk is portfolio rebalancing. Rebalancing is the systematic reallocation of assets within a portfolio either on a periodic or conditional basis.

To illustrate rebalancing, let’s look at an example. Suppose we invested $100 in a portfolio consisting of 50% stocks and 50% bonds. In this scenario, $50 would be invested in each asset class.

Over time, increases in the market prices of the underlying instruments may cause this investment to grow to $300. Since stocks tend to fluctuate more rapidly (or be more volatile) than bonds, the ratio of stocks to bonds within the portfolio may change over time.

As a result, the $300 ending value might consist of $210 in stocks and $90 in bonds. Since each allocation originally began at a value of $50, we can see that stocks increased in value to a greater extent than bonds, and as such, currently represent a greater portion of the overall portfolio.

Although the overall value of the investment has increased, the greater allocation to stocks means that any decrease in their value can potentially have a more significant downside influence on the overall portfolio. This may bring the overall risk level of the portfolio beyond that of the investor’s risk tolerance or capacity.

In this situation, rebalancing can be used to bring the portfolio back to the original intended risk/return ratio while maintaining its current appreciated value. In the above example, stocks (which currently comprise 70% of the portfolio) would be sold to bring the allocation of stocks back down to 50%, and bonds (which currently represent 30% of the portfolio) would then be purchased to bring the allocation back up to 50%.

The result of the rebalancing is a portfolio recalibrated to provide the returns sought by the investor while bringing the risk down to an acceptable level. Although rebalancing can be useful in bringing a portfolio back to its original risk/return characteristics, it can also be employed in response to changes in security prices, client circumstances, the financial markets, politics, or evidence that such changes may be likely to occur.

While portfolio rebalancing can make portfolios more flexible to changing conditions, it also allows investors to systematically “buy low and sell high” if a particular certain asset class experiences significant price appreciation within a short period of time. This might be a significantly advantageous to the investor because periods of outperformance may be followed by profit-taking by other market participants which puts pressure on asset prices. Additionally, short sellers, if significant enough in volume, may cause the price of a security to decrease after periods of outperformance. Therefore, it is important to employ a systematic and non-emotional approach of buying and selling which reduces exposure to downside market movements. This is an area in which portfolio rebalancing may be particularly useful.

When performing portfolio rebalancing, a comprehensive research-driven methodology is necessary. The goal is to avoid a mere exchange of outperforming asset classes for those which are underperforming, something which can negatively impact future returns. Alternatively, a more appropriate strategy might involve the construction of a new portfolio which includes securities and asset classes not previously held. This generally requires careful analysis of the financial markets, the political climate, and various qualitative and quantitative factors to maximize the changes for success while adhering to the predetermined risk/reward characteristics sought by the investor. Since every security type carries associated risks, certain types may be incompatible with an investor’s financial situation, goals, or risk tolerance.

Today’s portfolios are often just as dynamic and unique as the investors who hold them, and as such, this serves as only a partial listing of factors which must be taken into consideration when rebalancing a portfolio. Although there are unfortunately no guarantees against loss, diversification and rebalancing may serve as powerful tools to manage risk and minimize volatility within a portfolio.

As investors scour the financial landscape in the search for lucrative investment options, it is easy to be tempted by the lure of the potentially high returns often touted by issuers of non-marketable securities. These are financial instruments which may generally be exchanged for cash only by dealing directly with the issuer. Some issuers might require investors to lock in their capital for months or even years, while others limit the amount of shares which can be sold within a particular period of time. The result is that an investor may be required to hold the security despite the availability of other, possibly more attractive investment opportunities which may arise in the future.

It is important to distinguish between illiquid securities and those that are non-marketable. Illiquid securities may be freely bought from or sold to other investors however, transactions may not occur often and the amount of shares traded is usually small. Non-marketable securities, on the other hand, are limiting by design as they generally cannot be sold to outside investors either for a certain period of time after the initial investment or during the entire life of the investment.

When you invest in non-marketable securities, you are essentially placing a bet that your particular investment will outperform other available alternatives in the current year and in future years. This means that if a security is said to provide, let’s say, a steady 6% annual return on average, then you would essentially miss out on any returns provided by the market which exceed that 6%. If the market returns 10% in a given year, then the 4% difference is effectively the cost you pay for holding an inflexible investment.

On the other hand, that 6% average annual return may seem much more attractive when the market loses 30%. In this case, it may appear that the non-marketable investment would be paying off. However, the reality of the situation may be more complicated than it appears.

This is due to the fact that a security which promises a steady return is only as reliable as its intended source of income. In other words, the security may only provide returns to investors if it generates sufficient revenue through its underlying investments. This means that despite the steady distributions which may be touted by an issuer of non-marketable securities, it is rarely the case that an investment is completely immune to events occurring in the financial markets. As a result, significant market downturns may affect the ability of an issuer to make distributions to investors and/or protect their principal, even in situations in which the issuer promises stable, fixed returns. The investor may not become aware of this, however, until it comes time to cash out of the investment.

To illustrate this point, let’s consider non-marketable REITs (Real Estate Investment Trusts) as an example. A REIT is an investment vehicle which gives investors an opportunity to participate in the revenue earned from the hotels, office buildings, residential properties, interests in mortgage securities and/or other assets held by the Trust. Essentially, investors act as a conduit and provide the REIT with the capital needed to purchase the underlying assets with the intent of collecting future payouts.

As the process of purchasing and selling real estate can be quite complex, time-consuming, and costly, REITs often require investors to lock in their investment for a certain period of time before they can exchange their shares for cash. While this brings stability to the overall portfolio held by the REIT, investors may be paying the price for this stability by way of their long-term financial commitment.

This is because property prices, as most other variables in the financial markets, are subject to change. In the rapid pace and high liquidity of the stock market, such changes may be reflected almost immediately by decreases in the market values of securities relating to real estate. To illustrate this concept, consider an investor who purchased shares of a publicly-traded real estate company at $10 per share. In the event of a market downturn, each share may be worth only $8. This drop in price was the result of a consensus amongst a multitude of buyers and sellers who agreed that the fair value of the security at a particular time was $8 per share. Although the investment has dropped in value, the investor has the benefit of transparency regarding the price of the shares at a particular time, and also the ability to cash out if the losses exceed a certain predetermined threshold (also known as a stop-loss).

However, non-marketable REIT securities are not as transparent in this respect because the marketplace is comprised solely of the issuer and the investor. Therefore, the price may not be reflective of significant macro and microeconomic forces which would ordinarily influence the prices of marketable securities. Since the volume of transactions occurring within a given time period is usually quite small, changes in prices take longer to be priced into the value of a non-marketable REIT.

So for example, let’s say that one million investors bought a single share of a non-marketable REIT at $10 in 2006. The REIT could use these proceeds, up to $10 million, to purchase real property, mortgages, etc. This security can provide distributions to investors which are fueled by rents, leases, mortgage payments, and other capital inflows to the REIT. Suppose that after the financial crisis, the value of the property originally purchased by the REIT at $10 million drops to only $6 million. As investors attempt to redeem the shares that they paid $10 for in 2006, the REIT will only be able to pay out $6 per share. Even though investors received distributions from the investment, the value of the principal was significantly reduced over the years. Unfortunately, this may not be apparent to investors until it comes time to cash out their principal.

In this case, the $10 share price may not necessarily reflect the true value at a particular time because there are no recent trades between market participants to serve as a basis for that price. This is because issuers of non-marketable securities typically prohibit sales of interests to third-parties, which means that the security essentially does not exist outside of the agreement between the investor and the issuer.

As a result, investors holding non-marketable securities should carefully consider the share prices which are quoted to them and shown on account statements. If a particular security was quoted at $10 prior to the collapse of the recent financial bubble, it may be unrealistic to maintain the $10 valuation given that the prices of the underlying investments have fallen significantly.

It may be argued that since investors are receiving regular distributions from non-marketable investments, they need not consider current market prices. This logic is flawed, however, because the investors are relying heavily on the financial health and the investment success of the issuer to protect their principal. If the market prices of any underlying investments fall significantly, it may in extreme cases lead to the insolvency and/or bankruptcy of the issuer because it may not be able to buy back the shares from investors at the quoted prices. In such cases, investors in non-marketable securities may be left with pennies on the dollar as they are typically not insured against losses.

Aside from the risks associated with investing in non-marketable securities, investors should also consider the fees that are charged when entering in such investments. These fees may include commissions paid to financial professionals who profit based on volume of securities they sell. These commissions may in some cases result in conflicts of interest and cause non-marketable securities to be recommended to investors over other, potentially less risky investments.

With the wide variety of investment options currently available in the financial markets, investors may be better served by emphasizing liquidity and transparency when making their investment decisions. There are many alternatives available which may provide comparable returns with a lower level of risk than is available with non-marketable securities. If considering the purchase of a non-marketable security, an investor should consider whether the returns provided by the investment adequately compensate the investor for taking on the additional risk of holding the security while other, more lucrative alternatives may be available. The investor should also be mindful of the financial stability of the issuer, which can be a significant factor in influencing the outcome of the investment.

The purpose of this article is to provide insights without jargon and in plain English. As such, this article does not provide a comprehensive overview of all of the risks and benefits associated with non-marketable or illiquid securities. However, consideration of the risks outlined may help investors find securities which are more suited to their investment goals and objectives. Please note that REITs are just one of the many types of non-marketable securities currently being sold to investors. While some REITs are non-marketable, there are also marketable REITs that offer additional liquidity and those that are publicly-traded on established national stock exchanges.

Diversification has long been accepted as an effective tool for minimizing risk within a portfolio. This may be accomplished by investing across many different asset classes, security types, geographies and risk levels. A diversified portfolio can be designed to provide a desired level of returns while minimizing the likelihood that a loss on any particular investment would be seriously detrimental to the overall portfolio. The act of simply purchasing a multitude of various securities, however, may not deliver the full range of benefits that a more disciplined and sophisticated diversification strategy may offer.

One of the most important aspects of a diversified portfolio is the respective distribution of the invested capital amongst various investment types (stocks, bonds, REIT’s, mutual funds, etc). This allocation can dictate the probability and severity of losses (downside potential) that investors may be exposed to while pursuing their desired level of returns (upside potential). This is commonly referred to as the “risk/reward ratio”.

Typically, investors seeking rapid growth in their investments relied on portfolios consisting mainly of stocks because they offer the opportunity to participate in significant price increases over short periods of time. Consequently, investors relying mainly on stocks may also be subjected to rapid price decreases if the market turns against them. The tendency of a stock price to experience rapid price changes over time is known as volatility, which is often the cost investors must incur for the opportunity to participate in potentially significant returns.

To decrease exposure to downward movements in the market, investors have often turned to government-backed or highly-rated corporate fixed-income instruments, which are known to be less volatile than stocks. Lower volatility generally means less downside risk, but it also means that your portfolio may not keep pace with inflation. The reason is that investment-grade fixed-income instruments provide a lower level of return when compared to other investment types.

One alternative to investing in a single asset class is to invest in a portfolio consisting of both stocks and fixed-income instruments strategically allocated to achieve a predetermined risk/reward ratio. With this model, more conservative investors may choose to hold a greater percentage of fixed-income holdings, while more aggressive investors seek the greater return potential of stocks. So, for example, a portfolio may consist of 50% stocks and 50% bonds. This allocation provides the investor with an opportunity to achieve growth through stocks and offers some protection against market downturns through bonds. Although there are no guarantees against loss, a proper portfolio allocation may be useful in aligning an individual investor’s needs and goals with their tolerance and capacity for risk.