Understand Portfolio Rebalancing
Portfolio rebalancing is one of those terms that gets thrown around a lot but what exactly does it mean? Simply put, rebalancing your investment portfolio is the process of bringing your investments back to its original asset allocation. This is done to ensure that you’re not taking on too much risk or missing out on potential returns.
In the world of investing, things can change quickly. Market trends shift, economies rise and fall, and personal financial circumstances evolve. These factors can cause your portfolio to drift away from its intended allocation, leading to an investment strategy that no longer aligns with your financial goals or risk tolerance.
That’s where rebalancing comes into play. By periodically reviewing and adjusting your portfolio, you ensure that your investments remain aligned with your financial objectives. It’s a crucial part of investment management, but one that is often overlooked or misunderstood by beginner investors.
If you are new to investing and haven’t done so already, read my comprehensive guide to investing before reading on.
Why is Rebalancing Your Investment Portfolio Important?
Rebalancing your investment portfolio is about more than just maintaining a neat portfolio. It’s about mitigating risk and enhancing returns. Without regular rebalancing, your portfolio could end up overly weighted towards certain assets which could increase your overall risk or affect your long-term goals.
For instance, if stocks perform exceptionally well for a period, they could become a larger proportion of your portfolio than you initially intended, thereby increasing your risk exposure due to stock volatility.
On the flip side, if one of your investments underperforms, it may occupy a smaller proportion of your portfolio than you’d like. This could mean missing out on potential returns if that asset’s performance improves. Regularly rebalancing helps to keep your portfolio in line with your investment strategy and risk tolerance, ensuring that you’re well-positioned for long-term financial success.
Outside of these factors, another benefit, which may also be the biggest, is that rebalancing your investment portfolio keeps your emotions in check. Many beginner retail investors often believe that if an investment has performed well, then it will continue to do well. But the reality is that if an investment performs really well, it could just as easily retract and if you don’t realise your gains (take profit) you could just as quickly lose it.
At the end of the day, rebalancing your investment portfolio removes every form of speculation and helps keep us on track for long-term financial success! Keep in mind, though, that rebalancing isn’t a one-size-fits-all solution. The timing and approach to rebalancing can vary greatly depending on factors such as your investment goals, risk tolerance, and time horizon.
How Often Should You Rebalance Your Portfolio?
The question of how often to rebalance your portfolio is a common one. While there’s no definitive answer, as it depends largely on individual circumstances and market conditions, a good rule of thumb is to review your portfolio at least once a year.
Some investors prefer to rebalance based on time, such as annually or semi-annually. Others choose to rebalance when their portfolio’s allocation drifts a certain percentage from its target. For instance, if your portfolio’s allocation to equities increases by 5% or more, it may be time to rebalance.
Remember, though, that more frequent rebalancing isn’t necessarily better. Each time you rebalance, you may incur transaction costs, which can eat into your returns. Additionally, excessive rebalancing can lead to a portfolio that is overly reactive to short-term market fluctuations, potentially hindering long-term growth.
Three Tips for Successful Portfolio Rebalancing
Here are 3 tips to successfully rebalance your investment portfolio:
1. Set a target asset allocation and rebalancing schedule.
Your target asset allocation is the mix of different investment classes (e.g., stocks, bonds, cash) that you want your portfolio to have. This allocation should be based on your risk tolerance, investment goals, and time horizon. Once you have set your target asset allocation, you need to decide how often you will rebalance your portfolio. A common rebalancing schedule is quarterly or annually.
2. Consider rebalancing your investment portfolio using a threshold-based approach.
A threshold-based approach is a way to rebalance your portfolio when your asset allocation has drifted from your target by a certain percentage. For example, you might decide to rebalance your portfolio when your stock allocation is more than 5% above or below your target allocation.
3. Be mindful of costs and taxes.
Rebalancing your portfolio can involve buying and selling investments, which can generate transaction costs and taxes. To minimize these costs, you can try to rebalance your portfolio simply using new money to purchase underperforming assets.
Here are some additional tips for successful portfolio rebalancing:
- Before your annual rebalance, take a risk assessment test again to see if your asset allocation strategy needs an update. Then, realign your portfolio with your updated strategy as opposed to last year’s.
- Don’t overreact to market fluctuations. It’s normal for your asset allocation to drift away from your target over time. The key is to rebalance on a regular schedule, even if the market is volatile.
How to Rebalance Your Investment Portfolio
Rebalancing your investment portfolio might seem daunting, but it doesn’t have to be. The process can be broken down into a few simple steps.
First, review your current asset allocation and compare it to your target allocation. If there are any discrepancies, make sure to identify which assets are over or underweighted.
Next, decide on the best way to rebalance. This could involve selling some assets that are overweighted and using the proceeds to buy more of the underweighted assets, or as mentioned earlier, you could use new money to buy more of the underweighted assets. The latter is usually the best approach when you are investing regularly.
Finally, execute your plan. Once you’ve decided on the best approach, make the necessary trades. But, be sure to keep transaction costs in mind, and try to minimize the amount of trades you ultimately make.
Reminder Regarding Tax!
Remember that managing investments always come with tax responsibilities. Depending on where you are located you may have to pay capital gains tax on any investments that you sell at a profit, in addition to potentially also having to declare interest and/or dividend payments you receive. It is always a good idea to consult with a tax advisor before making any major changes to your portfolio.
Expert Advice on Portfolio Rebalancing
While rebalancing your investment portfolio can be a vital part of successful investment management, it’s not something to rush into without careful consideration. Here are a few pieces of expert advice to bear in mind.
- Don’t rebalance too often: While it’s important to ensure your portfolio stays in line with your investment goals, rebalancing too frequently can lead to unnecessary costs and potentially lower returns.
- Consider all of your assets: When rebalancing, don’t forget to consider all of your assets, not just those in your primary investment portfolio. This includes your retirement account, real estate, and any other investments you may have.
- Rebalance in a tax-efficient manner: As mentioned earlier, rebalancing can have tax implications. Try to minimize these as much as possible, perhaps by selling assets with the least amount of gain first or by rebalancing within tax-advantaged accounts.
Successfully Rebalancing your Investment Portfolio
In conclusion, rebalancing your investment portfolio is a critical aspect of successful investment management. It helps to mitigate risk, stabilise returns, ensures that your portfolio aligns with your financial goals and leaves your emotions at the door.
So, whether you’re a seasoned investor or just starting out, make sure to regularly review your portfolio and rebalance at least once a year. And when you do, double check to make sure that your asset allocation strategy aligns with your new risk tolerance and updated financial goals.
Remember, if you’re unsure about how to go about it, don’t hesitate to seek professional advice.
