Too much of good thing? Share profits trigger need to rebalance portfolios

Many investors may be caught off guard with bloated share portfolios after a period of exceptional returns – it’s time to review the balance.

It pays to see if your investment portfolio is out of balance.

Investing is generally about achieving good returns. So what happens when good returns put your investment portfolio into a higher risk category than you would prefer?

Can an investor have too much of a good thing? It sounds totally contradictory, yet that’s exactly the scenario some investors may be facing right now.

And the reason largely comes down to what global sharemarkets have been doing for the best part of two years. In short, they’ve surged into record territory.

Last year alone, the MSCI World Index – which aggregates the sharemarket returns from 23 of the world’s largest developed countries – rose by about 21.6 per cent. Driving much of that gain was USs’ sharemarkets, which achieved their second straight year of returns above 20 per cent.

Generally speaking, investors with sharemarket exposures have done exceedingly well over the last couple of years. However, some may now be “too exposed” to shares. That is, if they have a medium-risk tolerance, their total exposure to shares, which can be prone to high volatility, may now be too high.

A simple calculation shows that investors who started out with a balanced portfolio in 2023 split evenly between shares and bonds, and who haven’t made any adjustments since, may now effectively have close to a 60-40 portfolio weighted towards shares. So, some portfolio rebalancing could be prudent to bring portfolios back into alignment.

Let’s take a hypothetical person, who at the start of 2023 created a $200,000 balanced invest­ment portfolio with equal value weightings to international shares (including Australian shares) and Australian fixed income (bonds).

To achieve them, they invested in fund products that tracked the holdings in the MSCI World Index and the Bloomberg AusBond Composite Index. By the end of 2024, thanks to their initial $100,000 investment into international shares, the value of the shares exposure had increased by more than 50 per cent to $150,400. The value of their Australian bonds exposure had risen marginally, to $108,100.

How has the recent sharemarket rally tilted your investments?

Based on their increased total portfolio value of $258,500 at ­December 31, 2024, this meant their portfolio weighting to international shares had risen from 50 per cent to 58.2 per cent, while their allocation to Australian bonds had fallen from 50 per cent to 41.8 per cent.

In plain language, it had shifted from being a balanced portfolio to an unbalanced one – lopsided in both value and percentage terms towards shares.

The numbers look slightly better over just one year, but even still, a hypothetical $200,000 balanced portfolio created at the start of 2024 (with $100,000 invested in international shares and $100,000 in Australian bonds) would have drifted out of alignment.

The shares component of the portfolio would have increased in value to $121,600, taking its portfolio weighting from 50 per cent to 54.2 per cent. Although the bonds exposure would have risen in value to $102,900, their portfolio weighting would have dropped to 45.8 per cent.

It’s highly probable that many investor portfolios have moved well out of kilter with their intended strategy, and risk allocations, over the past one to two years.

So, what could you do about it? When faced with the decision on whether to rebalance a portfolio, remember that the fundamental purpose of rebalancing is risk control, not enhancing returns.

Some investors may be happy to make no portfolio changes at all and effectively let investment ­nature take its course. Having a riskier exposure than before may be tolerable, but it is important to understand the risks and potential investment consequences.

On the other hand, investors wanting to maintain set portfolio weightings may be inclined to restore their allocations by selling shares or buying bonds.

In the balanced portfolio examples, based on the recent international shares and Australian bond returns, one method to restore a 50-50 split would be to sell some shares and use the proceeds to top up the allocation to bonds.

Alternatively, an investor could maintain their shares exposure and use other capital to increase their exposure to bonds.

Make no mistake, keeping investment portfolios aligned to specific asset weightings is a difficult and ongoing exercise. In addition, there are usually trading costs involved and there could be tax consequences from asset sales.

Professional portfolio managers, who need to keep certain products aligned to specific weightings, rebalance holdings on an ongoing basis. This typically involves using daily cash flows to buy underweight assets to minimise turnover and reduce the realisation of capital gains.

Keeping investment portfolios aligned to desired asset weightings demands a disciplined approach focused on making sure asset exposures don’t move too far out of kilter, and which also takes into consideration transaction costs and potential tax liabilities.

It’s also worth noting that asset weightings can sometimes move back into alignment by themselves, purely because of price movements on financial and other investment markets.

Professional asset managers often choose to only make small portfolio adjustments if a portfolio deviates from its target allocations by a small percentage.

Whether you do it yourself or leave it to professional portfolio managers, there are clear benefits in avoiding portfolio drift as much as possible.

Tony Kaye is senior personal finance writer at Vanguard

www.vanguard.com.au