A Map, A Compass, and a Portfolio Walk into a Bar…

Not really, but it’s a catchy headline, isn’t it? I ran across an article about rebalancing portfolios published by Vanguard, and it piqued my interest. Anytime I read things of a technical nature, I try to figure out an easy way to explain them. I can talk about standard deviation, correlation, and the various constraints of portfolio rebalancing, but I suspect no one really wants to hear about that. When I read this article, I imagined a fairly simple way to think about portfolio rebalancing – a compass. If you asked my wife, she’d tell you I thought of a compass because my college buddies and I recently returned from a hiking trip in Grand Teton National Park. While she is undoubtedly correct, I still think the metaphor holds true. Follow along, if you will.

It stands to reason that a four-day, three-night backpacking trip would involve some planning and preparation. That’s four days with no electricity, plumbing, kitchen, or any other modern convenience. It also makes sense that a good bit of gear will be needed for a trip like this. However, no amount of preparation or gear can fully prepare you for everything that you may encounter in the backcountry because nature is unpredictable. That’s not to say you just wing it and hope for the best; quite the opposite. You prepare, and you expect the unexpected. To help ensure everyone’s safety and enjoyment, three things are vital to have on the trail:

A Plan

A Map

A Compass

If everything goes according to plan, the weather cooperates, and trails are well marked, you may not use your map and compass much. But they are still helpful when you get to a trail intersection or if you want to know how many miles you’ve hiked that day. If things go badly, these tools can help you avoid danger, find shelter, or simply get back to a trail that you lost. This is not the sexy gear that you get excited about using – this gear is kind of boring. The technology hasn’t changed in centuries, but it hasn’t had to change because it works. It’s not designed to get you excited to be on the trail; it’s designed to help minimize avoidable risks and keep you on track.

So what could hiking, a map, and a compass possibly have to do with your portfolio? I’m glad you asked.

A Plan

Much like a hike, a portfolio has to be planned. I had been planning this trip with my buddies for months and it’s only six days from start to finish. Your portfolio is likely going to need to last more than six days, so imagine the amount of planning and preparation that should go into it. It will take your entire working life to accumulate, and you will need to support yourself through your retirement years. You and your advisor have carefully discussed your goals and your fears, and have built a portfolio tailored to fit you and your needs. It is designed to help pursue the returns you need without being subject to undue risk. But just like Mother Nature, the markets are unpredictable. So how do you keep your portfolio on track through both the sunny days and the stormy nights of the markets? You use a map and a compass.

A Map

The map for your portfolio is an Investment Policy Statement (IPS). In addition to laying out the expectations of the advisor and the investor, the IPS tells you where your portfolio should be. For example, it may tell you that you are supposed to have 60% stocks and 40% bonds (60/40) in your portfolio. If you were on a trail, “60/40” is the trail where you should be walking. As the markets move, those numbers will move. Say stocks have a great run and your portfolio drifts to 75% stocks and 25% bonds (75/25). The good news is your portfolio has likely grown, so you’re probably happy; however, now with 75% stocks, you have more risk in your portfolio than you did when you had only 60% stocks. You may be hiking closer to the edge of the cliff than you’d like to be. You’ve gotten off trail a little bit and need a way to get back. Enter the compass.

A Compass

Just like a compass helps guide us back to the trail, our rebalancing strategy helps us get our 75/25 portfolio back to our desired 60/40. But how do we use that compass? Do we rebalance every time something gets slightly out of balance? If our portfolio goes from 60/40 to 61/39, do we need to rebalance and get back on the trail?

Remember how I mentioned that a compass is designed to keep you on track and minimize avoidable risks? The same is true of your rebalancing strategy. It can be tempting to think that it’s part of the overall plan to help enhance return, but the study found that not to be the case. We don’t rebalance portfolios because we are trying to squeeze out extra return; we rebalance them because we want to avoid risk. So when creating a rebalancing strategy, we have to consider how much extra risk we are comfortable taking and what the cost of avoiding that risk will be.

For many investors, a 5% difference from target weight to actual weight, or one annual rebalance, can be a good rebalancing target. With this strategy, you aren’t taking substantially more risk, and with the very real costs to rebalance a portfolio – taxes and trading costs – if you rebalance every time something is slightly off, you would incur unnecessary costs and potentially do more harm than good to the portfolio. That’s the same reason I use a compass instead of GPS when hiking. I could buy an expensive GPS, battery packs, solar chargers, and all that fancy gear so I could be sure with every step I took that I was on the trail, but that’s more cost than I’m willing to incur. I’m willing to chance veering off course slightly, knowing that my trusty $5 compass will get me back to the trail just fine.

And it never hurts to have an experienced guide. While a plan, a map, and a compass are wonderful tools, there is great comfort in having someone who walks these trails daily and is handy at using them. Whether it’s a backcountry guide or your Savant advisor, a guide can help you navigate through the emotionally tough times when fear or greed may tempt you to deviate from your plan.

Whether you are taking a multi-day trip through the Wyoming wilderness or managing your portfolio, never set out without a plan, a map, and a compass. And food. Food is important too!

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This is intended for informational purposes only and should not be construed as personalized investment advice. Please consult your investment professional regarding your unique situation.