1 Which Rebalancing Strategy to
Choose?
2 Theory vs. Reality
online report
The Subtle Art of
Rebalancing
summary
Effective asset allocation is not
just a one-shot deal. The process
of rebalancing your portfolio can
be an essential tool for maintain-
ing the long-term health of your
investment account. However,
saying investors should have a
rebalancing strategy is one thing,
but determining what that strat-
egy should be is another. There
are several rebalancing strategies
that investors may wish to con-
sider, and several factors that may
contribute to a strategys success.
Your Financial Advisor has the
resources available to help you
select and implement the strategy
that may be most appropriate for
your portfolio.
how do you tell when your portfolio needs a tune-up?
S uccessful investing starts with a
sound, diversied asset alloca-
tion planone that matches your
long-term nancial objectives, return
expectations and tolerance for risk.
However, choosing from among the
thousands of investment options
available in todays markets to create
that ideal portfolio can be a challeng-
ing task. Working with your Finan-
cial Advisor, you can determine the
combination of asset classes and in-
vestment products that may be most
appropriate to meet your needs.
Effective asset allocation, though,
isnt just a one-shot deal. Its an on-
going process that requires careful
review to ensure that any course
corrections that may be necessary
are made. This process is known as
portfolio rebalancing.
In todays fast-paced markets, an
investor who doesnt have a rebal-
ancing strategy could be asking for
trouble. Leaving a portfolio untended
for long is like going months without
taking your car to the mechanic once
the check-engine light ashesthe
consulting group
outcome depends far too much on
chance.
Over time, market conditions can
change drastically, creating new risks
or new opportunities. Returns on
some assets may lead or lag the rest
of the portfolio, causing it to drift
from its original allocation. This may
leave investors exposed to far more
risk than they want or expect. Unfor-
tunately, many self-directed investors
choose to ignore these risksuntil its
too late to avoid them.
which strategy to choose?
Saying investors should have a
rebalancing strategy is one thing, but
saying what that strategy should be
is another. A variety of rebalancing
rules of thumb have been suggested
and debated by investment profes-
sionals. These include:
periodic rebalancing. The
portfolio is reset to its target allo-
cations on a xed schedulesuch
as annually, quarterly or monthly.
This rule has the virtue of sim-
plicity, but can lead to frequent,
relatively minor changes.
online report / the subtle art of rebalancing
threshold rebalancing. The
portfolio is adjusted if an asset
class moves from its target by more
than a certain amountsay plus
or minus 5%. While this is a more
exible rule, in volatile markets
it can also trigger a lot of dubious
buying and selling.
range rebalancing. Similar
to threshold rebalancing, except
asset classes are adjusted back to
the limits of their ranges (to use
the previous example, the target al-
location plus or minus 5%), rather
than the target allocation itself.
volatility-based rebalancing.
Range limits for each asset class
are based on their expected volatil-
ity. So the rebalancing thresholds
for, say, small-cap stocks would
be wider than for, say, short-term
bonds.
active rebalancing. Portfolios
are rebalanced as needed, based
on analysis of market conditions.
This is similar to tactical asset
allocation, which seeks to exploit
shorter-term changes in market
values.
In theory, at least, rebalancing
should allow investors to earn higher
returns at lower risk. In part, this is
because the rebalancing process is
contrarianit involves selling assets
that have appreciated, and buying
assets that are temporarily out of
favor.
Such periodic course corrections
may help you keep your portfolio
from becoming overloaded with asset
classes that have risen too far, too
fast.
Rebalancing also tends to
reinforce one of the main benets
of diversication: the tendency of
returns on different asset classes
to offset each other over time. By
staying close to their target mix,
investors may reduce portfolio
volatility. This can permit the power
of compounding to work more
quickly, boosting long-term return
potential.
theory vs. reality
Life, however, is quite a bit more
complicated than theory. The ben-
ets of rebalancingand thus the
right rebalancing strategy for each
investordepend on a host of factors.
Most individual investors, for
example, have to pay taxes. Frequent
rebalancing may generate sizable
capital gains tax liabilities, offset-
ting any improvement in returns. So
a strategy suitable in, for instance,
a tax-deferred account, such as a
401(k) plan, may be inappropriate for
a taxable investment vehicle.
Investors also have to weigh many
of the same factors they considered
in their original asset allocation plan,
such as the expected returns and
risks of the assets in their portfolios.
In general, rebalancing works best
when:
return differences are nar-
row. If one asset class consistent-
ly posts higher returns over the life
of the portfolio, rebalancing away
from that asset class may reduce
returns, not increase them.
market volatility is high.
The more volatile the assets in a
portfolio, the greater the benets
of smoothing portfolio volatility
with offsetting returns.
correlations are low. Cor-
relation measures the degree to
which different assets track each
other. The lower the correlation,
the more their returns tend to off-
set each other, reducing portfolio
volatility.
The problem: These statistical
relationships arent xed in stone,
meaning a particular rebalancing
approach may yield very different
results over different time periods.
Morgan Stanley analysts have
examined the track records of various
mechanical strategiessuch as when you have a steady arm to lean
monthly or quarterly rebalancing
over various periods. They found
that while some strategies worked
well in some time periods, none
delivered consistently superior
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returns. In virtually all cases,
however, mechanical rebalancing
did reduce portfolio volatility. This
suggests investors who are primarily
concerned about risk may benet
from a simple rebalancing rule.
Morgan Stanley has also examined
several active strategies, in which
rebalancing moves are triggered
by changes in relative valuations,
risk premiums or other measures.
Such strategies were more likely
to boost returns compared to
mechanical rebalancing rules.
However, the complexity of these
active approachesand the tax costs
associated with themmay make
them unsuitable for many individual
investors.
conclusion
Like many investment issues,
portfolio rebalancing is a complicated
problem with no easy answers. For
managed money investors, complexi-
ty is magnied by the need to allocate
funds among portfolio managers, not
just asset classes. This may add yet
another added layer to the rebalanc-
ing process.
Fortunately, your Financial Advi-
sor is well-positioned to advise you
on these issues. He or she can help
you develop a rebalancing strategy
that takes into account your invest-
ment objectives, time horizon, risk
tolerance and other relevant factors.
Keeping your balance can be easier
on. For more information on how
Morgan Stanleys investment advi-
sory programs can help you maintain
your nancial equilibrium, speak
with your Financial Advisor.
2
online report / the subtle art of rebalancing
Asset allocation, diversication and rebalancing do not assure a prot or pro-
tect against loss. There may be tax implications with a rebalancing strategy.
Please consult your tax advisor before implementing such a strategy.
Investing in the market entails the risk of market volatility. The value of
all types of securities may increase or decrease over varying time periods.
Although the statements of fact and data in this report have been ob-
tained from, and are based upon, sources that Morgan Stanley believes to be
reliable, we do not guarantee their accuracy, and any such information may
be incomplete or condensed. All opinions included in this report constitute
the Morgan Stanleys judgment as of the date of this report and are subject
to change without notice. This report is for informational purposes only and
is not intended as an offer or solicitation with respect to the purchase or sale
of any security. Past performance is not a guarantee of future results.
Morgan Stanley Smith Barney LLC, its afliates, and Morgan Stanley Fi-
nancial Advisors do not provide tax or legal advice. This material was not
intended or written to be used for the purpose of avoiding tax penalties
that may be imposed on the taxpayer. Individuals are urged to consult their
personal tax and legal advisors before making any tax or legal-related deci-
sions.
2012 Morgan Stanley Smith Barney LLC. Member SIPC. Consulting
Group is a business of Morgan Stanley Smith Barney LLC.
2010-PS-1545 10/12
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