How To Rebalance Your Investment Portfolio
- Let’s have a look at how portfolio rebalancing works. In a word, rebalancing is selling one or more assets and reinvesting the proceeds to reach your target asset proportions. In order to realign your asset allocation with your risk tolerance, you would either sell some of your stock investments and transfer the money into bonds or buy more bonds or any other asset class in the portfolio.
- Why is balancing and rebalancing a portfolio so important?
- The goal of portfolio balancing is to attain your ideal risk and return potential proportions in your investment portfolio.
- When you first design and commit funds to an investment strategy, that is known allocating your assets. As a simplified example, you may want to have 70% of your portfolio in stocks and 30% in bonds. When you initially fund your portfolio in this manner, it would be what you consider a balanced portfolio.
- The issue is that these proportions in your portfolio do not remain constant over time. Let’s imagine the stock market doubles in value in five years, while the bond market rises at a slower rate. The value of the equities in your portfolio would outperform the value of the bonds, putting your investment portfolio out of balance dramatically.
- You can and should rebalance your investment account to maintain a balanced portfolio over time. If your original risk tolerance spurred you to invest 70% of your money in stocks, then your rebalanced portfolio should be 70% stocks once again.
- Which rebalancing method is ideal?
- Option 1 : Sell high-performing investments and buy lower-performing ones.
- Option 2: Allocate new money strategically. For example, if one stock has become overweighted in your portfolio, invest your new deposits into other stocks you like until your portfolio is balanced again.
- You may prefer the second option because rebalancing in the “traditional” way — without investing any additional money — requires you to sell your highest-performing assets. We’re generally fans of the second option since rebalancing by contributing new funds enables you to leave your winners alone to (hopefully) continue to outperform.
- Determining how a balanced portfolio looks for you
- Unfortunately, there’s no perfect method of determining your ideal asset allocation in a balanced portfolio.
- One method of determining the best asset allocation for you is called the Rule of 110. Subtract your age from 110 to determine what percentage of your portfolio should be allocated to stocks, with the remainder mostly in bonds. For example, I’m 39, so this means that about 71% of my portfolio should be in stocks, with the other 29% in bonds.
- You can use this method, but it’s also important to consider your individual situation. For example, if you consider yourself to be a risk-tolerant person and short-term market fluctuations don’t bother you, then your balanced portfolio could shift a bit in favor of stocks. On the other hand, if stock market volatility keeps you up at night, then you can err on the side of caution by allocating more money to bonds or even to cash. A portfolio that is balanced for me may not be — and is probably not — balanced for you!
- When should you rebalance your portfolio?
- Once you’ve determined your target asset allocation and have created a balanced portfolio, the next logical question is, When should I rebalance my portfolio?
- There are two basic approaches to rebalancing. You can either rebalance your portfolio at a regular interval (such as once a year) or just when it becomes plainly unbalanced. There is no right or wrong way to rebalance your portfolio, but once or twice a year should do unless your portfolio’s value is exceptionally volatile.
- One big advantage of portfolio rebalancing for long-term investors is when market values plummet, our tendency is to liquidate our holdings before things worsen. And, when market prices appear to be rising and “everyone” appears to be making money, that’s when we want to invest. This is natural human behaviour, yet it is the polar opposite of buying low and selling high.
- One of the most significant advantages of having a balanced portfolio over time is being compelled to sell high and purchase low. For example, if the stock market falls and equities lose 30% of their value, your bond allocation is likely to become excessively high in your portfolio. Selling some of your bond investments and buying equities while they’re cheap could help you restore balance to your portfolio. Having a well-balanced portfolio and taking steps to maintain it can help you avoid depending too heavily on emotions when making key investing decisions.
Source: Pickright