The Tao of Portfolio Rebalancing
Finding balance in life can be an endless quest. Fortunately, you can find balance in your portfolio whenever you desire it.
Rebalancing is a common strategy in investing. A balanced portfolio is one where investment dollars are divided among assets at the original proportions set by the investor. This is asset allocation. Although the market may be efficient, it is fleeting for many of its followers. Over time, the market will cause disorder in any portfolio; eventually, some assets will rise and some assets will fall. That’s why a perfect portfolio is unattainable, unless you can foresee the future, in which case you can find more exciting things to do with your time than track the S&P 500.
Therefore, it is essential to keep asset allocation harmony by rebalancing your portfolio. A rebalanced portfolio allows you to better maintain your desired amount of risk and reach your desired rate of return. Disciplined rebalancing also prevents you from taking precarious action. When things become disordered, we all have a natural tendency to emotionally react and alter plans. And, that will really mess up an investor’s financial mojo.
What is the meaning of rebalancing?
Rebalancing refers to adjusting your portfolio back to its original asset allocation. As an enlightened investor, you build your portfolio by allocating investments across different asset classes, like stocks and bonds, based on your risk tolerance and financial needs. Diversification across asset classes helps lower volatility while increasing the probability of long-term growth since your money is not tied to the performance of a single asset class.
However, market movements may eventually cause one or more asset classes in your portfolio to grow more than others, knocking them out of balance. The meaning of rebalancing is to keep your allocations in place so that you stay on your strategized path toward your long-term financial goals.
The prudence of rebalancing
By rebalancing your portfolio, you’re seeking investment tranquility by warding off market volatility. Simply, resetting your asset allocation maintains your diversification and your desired risk position. One asset class won’t come to dominate your portfolio and subsequently increase its volatility.
Therefore, your portfolio is better protected from major losses during market swings, leading to a higher probability of greater returns over time. Neglecting to rebalance your portfolio is a risky way of putting faith in one asset class and hoping it never lets you down.
The steps to portfolio rebalance
The steps to achieving portfolio rebalance are few. In essence, you sell your high asset classes and buy more of your low asset classes in order to keep your allocation levels in place.
For example, envision your portfolio’s asset allocation at 50% in stocks and 50% in bonds. After a boom in the stock market, your stock allocation rises to 60% while your bond allocation drops to 40%. In order to rebalance back to your original 50/50 allocation, you sell 10% of stocks and buy 10% more bonds. Your portfolio is now rebalanced.
Creating a rebalancing cycle
The frequency in which you rebalance is a choice made within. That is, you may rebalance how often you want. Ideally, you consistently abide by a certain method such as after a fixed period of time or fixed percentage change in allocation. But, if it helped you better remember, you could even base your rebalancing strategy on planetary alignments.
Typically, investors rebalance according to a calendar or percentage benchmark. When you follow a calendar method, you rebalance after a certain time frame; for example, on a specific date every year. Rebalancing once a year requires minimal monitoring and trading, plus it is easy to remember. Meanwhile, a percentage method involves rebalancing each time asset allocations drift from their targets by a specific percentage. The scenario above is a representation of the percentage method if you decided to rebalance after shifts of 10%.
Since the percentage method is more exacting, individual investors may find it easier to annually rebalance. Additionally, you may have to rebalance after depositing or withdrawing cash as well as after the payment of dividends and interest. No matter what rebalancing method you choose, it is important to stay dedicated to it and do it whenever needed.
The conventional wisdom of rebalancing
The idea of selling outperforming asset classes to buy underperforming asset classes may come as a revelation to some investors. After all, it sounds counterintuitive to the natural desire to hold growing assets in order to beat the market for better-than-average returns. In fact, rebalancing is essentially following the age-old, venerable doctrine of all investing: buy low and sell high.