When was the last time you reviewed your investment allocation?

June 1, 2012
If it has been more than a few months, it’s certainly worth taking a minute to stop and look at your investment allocation.

By John K. McGill, JD, CPA, MBA, and Brett Miller, CPA, CFP®

If it has been more than a few months, it’s certainly worth taking a minute to stop and look at your investment allocation. The surge in investment volatility over the past decade has led many doctors to experience numerous periods of both strong market rallies and painful declines. In fact, the last few years alone have seen more 100-point intra-day swings in the Dow Jones Industrial Average than at any point in recent history.

Collectively, these rapid market fluctuations impact the asset allocations of many doctors’ investment accounts. In periods of strong equity rallies, doctors see their equity positions appreciate much faster than the fixed income portion of their portfolios. Conversely, during quick market declines, fixed income retains its value much better than equities. In both situations, doctors need to be aware that market movements are increasingly causing investment portfolios to fall out of alignment with their target asset allocations.

In order to maintain a disciplined, long-term investment approach, doctors should strategically rebalance their portfolios based on measurable market criteria. In a recent SmartMoney.com article, investment columnist James Stewart explains the “common sense” system of strategic rebalancing. When the markets fall 10% from a previous high, doctors need to review their allocations and purchase equities to rebalance their portfolios. When the markets rise 25% from a previous low, doctors should remain disciplined and trim equities to rebalance to their target allocation. Subsequent gains and/or losses would further trigger additional rounds of rebalancing.

The central idea behind the strategic rebalancing strategy is to restrict emotional decision-making. As equities appreciate, very few doctors want to scale back their winning positions. Even fewer doctors wish to purchase underperforming equities in a declining market. Yet this is exactly what prudent investors should do. After the market appreciates 25%, the likelihood of a pullback is greater than continued appreciation.

At that point, doctors should harvest some of the investment gains generated from the rally and hedge their equity exposure by selling overweight positions to bring the portfolio back into alignment with the target investment allocation. Doctors should also reallocate after a 10% correction. After a market decline, doctors will most likely have underweight equities and will need to purchase additional securities to bring their portfolios back into alignment. Strategic rebalancing forces doctors to buy low and sell high, even when emotions send signals to the contrary.

Additionally, the strategic rebalancing approach prevents doctors from making the critical error of attempting to time the market. Time and time again, doctors follow the crowd and wait to get more aggressive. Doctors usually do not decide to get more aggressive until after the markets realize a majority of the investment gains. Doctors also tend to panic and sell after the markets have declined sharply, thus locking in their investment losses. Strategic rebalancing helps prevent these market timing errors by providing systematic times to buy and sell based on the most recent market high or low.

Dynamic rebalancing is another strategy doctors should consider using to keep their investment accounts in line with their target allocation. The majority of doctors achieve their annual savings goals by contributing to a company-sponsored retirement plan. This account should be designed with a target allocation based on the risk tolerance and investment time horizon suitable for each doctor. As new contributions are deposited into the account, many doctors invest their deposits in the same manner as their original target allocation.

While seemingly well intentioned, there is an inherent flaw in this strategy. As new deposits are allocated, the best performing investments will become rapidly disproportional to the remainder of the doctor’s account. To avoid this, doctors should consider using dynamic rebalancing to invest all new deposits into the investments that are the most underweight relative to the original target allocation. This strategy will keep doctors’ investment allocations in check and assure they do not buy at the top of the market.

In today’s rapidly changing investment environment, doctors must keep an eye on their investment portfolios. Those who use a combination of strategic and dynamic rebalancing should feel extremely confident their investment accounts will stay in line with their target allocation, thus ensuring proper risk allocation and investment diversification.

John McGill, JD, CPA, MBA, provides tax and business planning services exclusively for the dental profession and publishes The McGill Advisory newsletter through John K. McGill & Company, Inc., a member of the McGill & Hill Group, LLC. Brett Miller, CPA, CFP®, provides investment advice through Select Consulting, Inc., a registered investment advisor and affiliate of the McGill & Hill Group, a one-stop resource for tax and business planning, practice transition, legal, retirement plan administration, CPA, and investment management services. For more information, visit www.mcgillhillgroup.com.

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