The Importance of Portfolio Rebalancing
Rebalancing a stock and bond portfolio can be a good way to manage risk, control emotions and maintain returns.
What Is Rebalancing?
Portfolio rebalancing is essentially the process of bringing your portfolio back to its original asset allocation. This is done by selling portions of investments that have performed well and using the proceeds to buy other assets that are underweighted in your portfolio.
The discipline of portfolio rebalancing helps the investor:
- Control risk: When markets rise and fall, it’s important to keep your assets aligned with your goals so that you stay on track for long-term success.
- Control emotions: When markets are volatile, investors may feel tempted to make changes that aren’t right for them—which could cause them to sell at exactly the wrong time.
- Maintain returns: If an investor were always selling when investments performed well and buying when they performed poorly, their performance would be worse than if they had stayed invested!
The Consequences of an Imbalanced Portfolio
Even worse, an imbalanced portfolio can lead to a potential loss of capital. Keeping your assets in the right proportion is like walking a tightrope: you want to keep your assets balanced without being too heavy on any one side or asset class. If you get too far out of balance, the risk is that you'll end up tumbling over and falling off the rope entirely. This can be incredibly costly if it happens at a time when markets are volatile or experiencing sharp fluctuations (more on that later).
A poorly diversified portfolio is also bad news for your performance in general—and for that matter, for your peace of mind as well. By not being properly diversified, the overall risk of the portfolio is highly concentrated and could subject you to risk that could be easily managed by broad market diversification. Since various sectors of the markets do not move in tandem with another, it's important to have a mix of assets that are not correlated. One example of this now is to see how poorly FAANG (Facebook, Apple, Amazon, Netflix and Google) stocks have performed in the past year compared to the huge run up from the last 60 months.
Why is rebalancing your portfolio important?
Rebalancing can help you avoid taking on too much risk. If you get caught up in the excitement of various stocks or a particular sector of the market that's growing quickly, it may be easy to overweight your portfolio with holdings from that sector or asset class. The main issue with this approach is that it exposes you to greater risk by concentrating your investments into a narrow range of assets than if you had a more balanced and well-diversified portfolio.
If you keep your portfolio balanced, you'll be able to ride out the ups and downs of the market without being overly exposed to any one asset class. This is especially important if you're nearing retirement age or have other financial goals that you'd like to meet in the near future.
An example of how rebalancing a portfolio works
Let's use a hypothetical example to illustrate how rebalancing can help you achieve your goals.
If you are an investor who is seeking growth in your portfolio, your original asset allocation target maybe 60% U.S. equities, 30% International equities and 10% in bonds. If your allocation drifts to and you have a higher percentage of International equities and bonds, you would rebalance the portfolio back to its original and intended target weights.
This disciplined strategy adheres to the principle of selling when prices are relatively high and buying when prices are relatively low.
This imbalance would lead to lower returns over time—a drag on performance known as sequence risk—and could cause some investors to miss out on gains associated with owning more equity indexes over the long term.
Why is balancing and rebalancing a portfolio so important?
It's important to remain in line with your goals. Your portfolio should be structured so that it will help you achieve your goals and objectives.
It's important to remain in line with your risk tolerance. If you are very risk-averse, then you shouldn't have a lot of stock in your portfolio; if you're more risk-tolerant, then you own more stock equities. The goal is to have a well defined asset allocation strategy that aligns with your risk style and preference.
It's important to remain in line with your investment objectives. If one of the things that matters most is growth in your portfolio, then it doesn't make sense for your portfolio to be heavily weighted in bonds or fixed income since it will impact the overall return in the portfolio relative to its risk.
When should you rebalance your portfolio?
You should rebalance your portfolio for the following reasons:
If your risk tolerance changes. This can happen when you get married, have kids, or lose a job. You may find that you're more willing to take on risks than before because of new personal circumstances such as increased family responsibilities or a desire to achieve financial freedom sooner.
Conversely, if you see yourself retiring in five years and want to protect what assets you have left by making sure they grow slower over time, then it makes sense to reduce some of the riskier assets in your portfolio (like stocks) while increasing others that are less volatile (such as bonds). The goal is always balance—not too much or too little risk—
A well-defined investment strategy, along with a disciplined rebalancing method, will help you manage the volatility of the markets and your emotions.
Work with a Trusted Advisor to Develop a Rebalancing Strategy returns.
As we stated earlier, rebalancing is one of the most basic investment principles: it means selling assets that have gained value in order to buy assets that have lost value. It's the best way to harness the power of diversification while reducing risk.
A Trusted Advisor can help you determine the best means of rebalancing--whether it's annually or semi-annually or a specific allocation percentage. The Trusted Advisor can ensure that the portfolio is always invested at its target allocation between stocks, bonds and cash (or other asset classes).
Once again, the reason rebalancing works is because it helps prevent extremes from developing in one area of the market by selling off winners when they become too expensive and buying more of those losers whose prices are low relative to their intrinsic values.
The bottom line is that rebalancing your portfolio can be a good way to manage risk, control emotions and maintain returns. It can help you keep your investment strategy on track and make sure it remains consistent with your goals and expectations. At the same time, you need to keep in mind that rebalancing involves costs—and these costs may outweigh any benefits if they occur too frequently or too often