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The Stewardship of Wealth: Successful Private Wealth Management for Investors and Their Advisors, + Website by Gregory Curtis

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Rebalancing Taxable Portfolios

As noted above, most of the research on the benefits of rebalancing was performed on investment portfolios that were exempt from taxes. Because the tax costs associated with rebalancing taxable accounts can be very substantial, this research is suspect in the private client world. As a result, rebalancing of family portfolios needs to be more of a qualitative than a quantitative process, although of course it should be both.

As a review, we need to keep in mind the purpose of periodic rebalancing. Let's assume that we start with a portfolio strategy that is exactly aligned with our target asset allocation. As time goes by, our portfolio will drift away from the target allocation, as various sectors of the markets rise or fall faster than other sectors. Over time, our equity allocations will tend to grow much faster than our cash and fixed-income portfolios, but over the short term the opposite phenomenon could occur. In either event, the risk level of our portfolio will have changed, eventually substantially.

Suppose, for example, our target allocation has 55 percent in stocks, 35 percent in bonds, and 10 percent in hedge funds. In the absence of rebalancing, we may wake up some day to find that our portfolio is now invested 70 percent in stocks, 15 percent in hedge, and 15 percent in bonds. This is a vastly more risky portfolio than we set out to own, and in a bad market environment it will be hit hard—far harder than we are likely to tolerate without ...

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