Rebalancing is the process of realigning the weightings of a portfolio of assets to maintain the original level of desired asset allocation (Investopedia, 2018). In particular, this first involves an investor assessing their risk profile and determining the asset allocation strategy suitable towards their investment goals. For investors who are more risk-averse, they may want to put more money into bonds, rather than stocks, and vice versa for investors who tend to be riskier.
As an example, take an investor’s optimal portfolio allocation of 50% in stocks and 50% in bonds to be the most suitable level based on their risk profile and investment goals. In a strong performing stock market over the course of several years, the percentage value of stocks in the portfolio will tend to rise and drive the asset mix, for example to 70% in stocks and 30% in bonds. As the portfolio weightings across assets have changed, so have the implied risk profile of the portfolio. Clearly, the original portfolio is less risky than the latter; however, the disciplined investor’s risk profile should not have deviated from what they had originally determined simply due to a stronger performing equities market. The purpose of rebalancing is to maintain the original desired level of asset allocation and in the above example, an investor can achieve this by selling some stocks and buying bonds to get their portfolio allocation back to 50/50.
To rebalance, first start with keeping a record of every cost in the portfolio which allows for changes to be easily made when you need to rebalance later on. We suggest using an Excel spreadsheet to track these costs. Next, an investor should set a future date to review the values of their investment positions and the allocation mix within their portfolio. At this step, you should calculate the different weightings and compare it to the original record. If it differs significantly enough from the original record, you can adjust. At the adjusting stage, the investor can rebalance and adjust the weightings to match the original asset allocation. This is the basic framework of rebalancing, but there are a few things to consider before rebalancing:
It’s rarely the case of wanting the same desired level of asset allocation over the lifetime of your personal investing career. A prime example is the change in the amount of risk one is willing and able to take on as they are approaching retirement. If you started investing in your early 20s; you may prefer a more risky portfolio –maybe a 70/30 split of stocks/bonds. As you get older and closer to retirement, the investor would probably want a less risky portfolio that can be maintained throughout retirement. For example, the investor would change their level of asset allocation to 50/50 which is a less risky portfolio. It is important to reassess your risk tolerance and investment goals to meet changing financial needs.
Consider that you have also diversified within your stocks. This means that your portfolio has many different stocks in various industries (for more info, check out this post). Let’s say ABC stock sees a significant increase in price from $10 to $50. This jump in price will make ABC stock a bigger portion of your portfolio. Your stock portfolio is now skewed; ABC stock could have jumped from 10% of your portfolio to 50%! This high-value stock can be rebalanced to maintain diversity. Rebalancing will allow the investor to redirect a portion of ABC stock into other stocks. This way, you can mitigate the risk by spreading the risk across multiple asset names and asset classes.
It is very time-consuming to assess your portfolio on a frequent basis. Having to calculate the different percentages can be very exhausting and tedious work. According to many sources, a best practice is to examine your holdings at least once a year at a minimum in order to ensure the asset mix is not too far off from your desired allocation strategy.
Remember to double check the costs involved with rebalancing. This includes transaction costs and tax considerations of readjusting your portfolio. It may not be advantageous to rebalance a portfolio which has only changed to 51% stocks and 49% bonds. These values are fairly close to the original allocation mix and you may skip rebalancing for that period altogether. Costs also reduce the return you’re likely to return in the long term; especially for people with smaller portfolios. However, the aim of rebalancing is to manage risk, and that should be taken into consideration as the fundamental reason behind associated transactions.
Rebalancing is a good way to maintain overall risk and maintain an active portfolio. Regardless of how the market is changing, rebalancing helps the investor stick to their investing plan and drive returns through a disciplined approach while maintaining their level of risk exposure.