Portfolio rebalancing is something people rarely do despite being essential for any investment strategy. As all investors know, considering goals, risk tolerance and timelines to determine the right portfolio allocations takes time. But by not monitoring your portfolio and rebalancing it every now and again it can easily stray from your intended allocations. This is because different parts of your portfolio almost always generate different returns and the risk profile of different assets continually changes. Therefore I think it is good practice to rebalance annually and often take stock when the new year rolls around.
To begin you need to find out whether you need to rebalance your investment allocations and by how much so you need to know what they currently are. This means totalling up all your stocks, bonds, cash and other investments to calculate the percentages of each asset class and type. Once you know what your percentages are and by how much they differ from your strategy you have to decide how you will rebalance. There are two ways to main ways to rebalance a portfolio:
- By using new money. When adding new money to a portfolio, the money should be allocated to those assets in asset classes that have fallen. For example, if bonds have fallen from 40% of the portfolio to 30%, to rebalance you would buy enough bonds to return them to their original 40% allocation.
- By selling “winning” assets to buy more underperforming ones. This forces you to buy low and sell high, which is difficult for some investors as they don’t want to part with winning assets although taking profits from your winners is often a wise strategy. As Sir John Templeton said: “The four most expensive words in the English language are, ‘This time it’s different’.”
There are several benefits to rebalancing your portfolio. Here I go through the key benefits in an effort to encourage you to do it regularly, something which is often far down on peoples’ priorities.
Maintain Risk Levels
One of the key benefits of rebalancing is to maintain roughly the same level of risk in your overall portfolio. Asset allocation is all about balancing risk and reward and depending on the direction of market fluctuations you could end up taking on risk that is either greater or smaller than you originally intended.
Rebalancing your investment portfolio also gives you an opportunity to review fund performance and make changes. For example, for funds that are underperforming you can sell them off and look for others.
Make Strategy Adjustments
Our tolerance for risk changes are we grow older and as we go through other big life changes. In general investors start off willing to take more risks but they become more conservative as they grow older. When reviewing your portfolio with a view to rebalancing it, you can also take the time to alter your investment strategy according to changing tolerance, financial goals and time frames.
Prevent ‘Analysis Paralysis’
One of the other key benefits I see to rebalancing is that it helps to prevent ‘analysis paralysis’ where you can spend so much time trying to work out the best way of doing something that you end up doing nothing at all. Rebalancing as a periodic activity takes some of the emotion out of investing and ensures you draw up a plan and review it periodically in a way that you can stick to knowing you have done a formal review based on rational considerations. In theory this will help you avoid panic selling at the bottom of a market and buying at the top. In essence, it maintains a disciplined approach to your investment portfolio strategy.
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