Pub. 2 2020 Issue 5

J U L Y / A U G U S T 2 0 2 0 20 nebraska cpas ARTFUL ACCOUNT REBALANCING BY DAVID TEPP, CPA, PFS, MBA, TEPP FINANCIAL PLANNING One surefire way to initiate an awkward discussion with a client is to advise selling off part of an investment that is earning an excellent return. Particularly during bull markets, seldom does proper account rebalancing lead to improved near- term rates of return. Instead, the objective of rebalancing is to reduce the risk within a portfolio. Security Selection & Portfolio Testing Before selecting individual securities for a portfolio, investment correlation should be carefully considered. For example, large cap and mid cap equities have a relatively high positive correlation, so shifting assets from one to the other may not reduce the client’s risk. However, shifting from equities to certain bond securities where the correlation is lower will likely reduce risk. Once you have assessed the client’s risk tolerance and constructed a portfolio, it is critical to analyze how it would have responded to past financial crises. Investment analysis software can enable you to calculate how the portfolio would have performed during the COVID-19 outbreak, the 2008 mortgage crisis, and the 2001 tech bubble, to name a few. Once the portfolio is stress tested, the investment manager should then analyze security correlation and adjust the holdings as necessary to reduce risk. Timely Rebalancing Investment managers will often choose to rebalance quarterly, semi-annually, or annually depending on the size of the account. However, far more important than the time interval is the timeliness of rebalancing. The primary objective of all investors is, naturally, to “buy low and sell high.” Rebalancing accounts based on price volatility enables the investor to trim holdings that have grown beyond their intended target (selling high) and acquire less expensive diversifying assets (buying low). For volatility-focused rebalancing, it is critical to establish parameters that trigger activity only when appropriate. Overly sensitive parameters will result in heavy trading that can increase costs. Alternatively, if the parameters are too broad, the account will drift beyond the intended allocation and increase risk. “Account rebalancing should be designed to evaluate the account perpetually but to trade only when necessary,” says Dan Skiles, president of Shareholders Service Group, a SanDiego-based broker- dealer which specializes in serving independent advisors. “Further, it is critical to have trading desk support that can assist advisors with establishing model portfolios and determining best practices.” Mitigating Taxes For taxable investment accounts, the obvious initial objective when rebalancing is to avoid generating too high a tax liability