Portfolio Rebalancing

By Roshan Pourghasemi

Abstract

Over time, the percentage of each asset class in your portfolio deviates from what your desired allocation is. To combat this, an investor must periodically rebalance their portfolio back to what it originally was. Portfolio rebalancing is also used when an investor's financial goals change, and they must change their portfolio to reflect that. Generally, if you have over performing assets, you would want to take those high returns and reinvest them back into your underperforming assets, but there are many ways to rebalance.

One of the first steps that an investor should take when they start out is to decide on how much of their portfolio they are going to allocate to each asset class. This goes hand in hand with your risk tolerance and time horizon, so your portfolio’s diversification is something you should keep in mind. If stock prices rose over a period of time, for example, your portfolio’s diversity could be at an undesirable amount. That’s where rebalancing comes.

Key Takeaways

• Portfolio rebalancing is the periodic reallocation of assets in an investor’s portfolio to keep the portfolio at the desired level of diversification.

• You should consider rebalancing your portfolio annually, at the very least, but many investors opt to review their portfolio semi-annually, quarterly, or even monthly.

• Rebalancing is used to lower the risk of your portfolio and maximize your potential returns.

• Rebalancing is also used to change a portfolio based on changing investment goals and risk tolerance levels.

• A common way to rebalance is to take the high returns from your over-performing assets and put them into your underperforming assets until the levels are back at desirable levels.

What is Portfolio Rebalancing?

Portfolio rebalancing is the act of fixing a portfolio’s changed asset allocation to return to the asset diversification that the investor originally desired. Portfolio rebalancing is designed to inhibit an investor’s exposure to unwanted risk and allow them to capitalize on potential rewards. It also allows an investor to keep their portfolio with their area of expertise.

Most portfolio’s are some combination of stocks and bonds, and, since the price of stocks are volatile, the asset class diversity of the portfolio can vary greatly over time. If the value of the equities in a portfolio cause the allocation in stocks to rise above their desired percentage, it is probably time for a portfolio rebalance.

Also, investors may want to change the overall portfolio risk to meet their changing financial needs. If an investor needs to increase their potential for returns, they could benefit from putting a larger percentage of their portfolio towards equities. On the other hand, if an investor’s risk tolerance decreased, then they would want to allocate less of their portfolio towards equities and put more of their money into securities like bonds.

How Often Should I Rebalance?

The general rule of thumb is to check your portfolio every six months and follow the 5 25 rule. According to the 5 25 rule, you should rebalance your portfolio if an asset class has changed by either an absolute 5 percent or by 25 percent of the original target, whichever is less. Rebalancing can happen whenever you want, however, and many investors find themselves rebalancing annually, quarterly, or even monthly.

It is important to keep in mind the potential cost associated with rebalancing when you set out to decide how often you will rebalance. It involves buying and selling securities, which may involve transaction fees. Capital-gains tax is another consideration, as it occurs on the profits of investments you have sold. Furthermore, if you increase securities that have appreciated to rebalance your portfolio, you may miss out if they experience continued upward growth. To that end, if you rebalance when it is not necessary, you will experience unnecessary losses.

Why does Rebalancing Work?

Rebalancing allows investors to take the gains from high-performing areas and reinvest them in areas that are expected to see notable growth in the future. Of course, you risk missing out on the potential returns if those high-performing areas continue to grow. Still, if the current market conditions are inflating some of your assets’ values, you would benefit from rebalancing. Due to the market’s volatility, those high-performing assets could rapidly come down. If you were to rebalance, you would experience fewer losses and this generates higher returns in the long run.

You should always reevaluate your risk tolerance and time horizon when investing. Rebalancing allows you to stick to your investment plans, no matter the market conditions. This both builds investing discipline and strengthens your portfolio. If your portfolio becomes dominated by equities, you will be taking on much more risk than you originally anticipated. Rebalancing allows you to reduce the risk that was created in your portfolio and benefit from the returns of your investments that are performing especially well. The opposite is true as well. If you find yourself in a financial situation that allows you to be riskier with your investments, then you may benefit from rebalancing your portfolio in favor of higher risk securities like stocks.

An area of personal finance where rebalancing has extensive use is retirement funds. As you get closer to retirement, your risk tolerance lowers. Because of this, you would want to allocate more of your portfolio into fixed-income securities, making rebalancing a must.

How to Rebalance Your Portfolio?

If you already have a strategy for what specific investments you would like to sell and buy, you are just a little bit of math away from your next moves. Of course, you could do it yourself, but I would recommend having the internet do it for you.

Historically, investment professionals have recommended a few strategies.

1. You could funnel your dividends into underperforming asset classes until your portfolio’s diversification is back at the desired levels.

2. A simple but robust method is to purchase new investments in the underperforming classes until things even out.

3. The opposite is also possible. You could sell your high performing assets and use that money to bring the underperforming asset classes back the desired allocation. It helps to have a financial professional help you decide which assets to offload. Typically, this will end up being overvalued assets.