When discussing investment success, the focus is frequently placed on long-term investment returns, adjusted for risk. Sure, most investors discuss performance, but fewer think about the tools and strategies for achieving long-term portfolio success. One of the key success factors for building a sustainable long-term strategy is the practice of portfolio rebalancing.
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What is portfolio rebalancing?
Portfolio rebalancing is the process of periodically realigning your portfolio to achieve a desired, predetermined asset mix. In other words, it means making sure your portfolio aligns with both your investment goals and how much risk you’re willing to undertake. These two are intertwined since your goals directly determine your risk tolerance.
How does portfolio rebalancing work?
In general, the asset mix in your portfolio comes together based on a handful of specific factors. These include your age, income, risk appetite, and expenses. Working with you, and with the above factors in mind, your asset manager will determine an ideal asset allocation.
What is asset allocation? Essentially, it ties into the ever-importance of diversification of your investments. It’s a cardinal rule that you shouldn’t hold a single type of asset in your portfolio. Allocating your money to a variety of assets — typically a mix of stocks, bonds, cash and/or alternative investments — means that if one of these fails, you’ll likely be ok since you hold other assets. Good asset allocation basically means that your proverbial eggs are not all in the same basket.
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How to rebalance your portfolio
Investing being what it is, asset values will naturally fluctuate over time. This alters the portfolio’s asset mix. When one asset class outperforms the other, the result is higher than the desired weight of that asset class in the overall portfolio. In order to keep the established balance that works for your financial goals, rebalancing means selling assets and using these funds to buy other assets to get your portfolio back where it was. Alternatively, you could invest new funds in stocks that’ll help balance your portfolio.
Here’s an example, using the “classic” 60% stocks, 40% bonds asset mix. Let’s assume that the stocks in your portfolio outperform bonds and therefore increase in value quicker than the bonds, all else being equal. As a result, your portfolio asset allocation is now 75% stocks – 25% bonds. In order to bring the portfolio back to its target asset mix, you’ll need to rebalance by selling a portion of your stocks and using the proceeds to buy bonds. This process restores the portfolio to its target allocation of 60% stocks and 40% bonds.
Note: if you’re investing through a robo-advisor, rebalancing is likely done for you, automatically.
When should you rebalance your portfolio?
While rebalancing is easy in theory, it is much harder to apply in practice. Human emotions often get in the way, making rebalancing much more difficult to execute. It’s tough for investors to justify selling an asset class that’s performing well and buying an asset class that’s underperforming, just to get back to the target allocation, all while markets are running up and portfolios are making money. But, this is precisely when one should rebalance.
Portfolio rebalancing may seem counterintuitive, however, it supports the “buy low, sell high” investment mantra. A disciplined rebalancing process forces investors to sell the outperforming “expensive” asset and buy the underperforming “cheap” asset. Furthermore, rebalancing ensures portfolios stay well diversified, in addition to locking in profits from investments.
How often should you rebalance your portfolio?
Rebalancing is a dynamic process. There are no hard and fast rules for the frequency of portfolio rebalancing.
Typically, ranges of +/- 5% or 10% are set around the weights of assets when creating the target asset mix. For example, again using a portfolio with the classic 60-40 balance: if we use 10%, then the acceptable range for stocks is 50% – 70% and the range for bonds is 30% – 50%. These ranges allow asset allocations to increase (or decrease) giving the portfolio room to benefit from growth in performing investments, without triggering a need to rebalance too frequently.
Rebalancing should occur when assets breach the allowable range around the target — whether quarterly, semi-annual, or another predetermined timeline.
Asset allocation should always be monitored, especially before extraordinary events that could cause sudden shifts in value.
Just remember: this is a risk management tool. Portfolio rebalancing, and sticking to your ideal asset allocation, removes a lot of the emotion from the investing process. By staying true to long-term investment objectives, you can avoid the pitfalls of short-term investing. Ultimately, you’ll have better odds of achieving investment success.