Rebalancing is all about getting a portfolio’s asset allocations back to the levels set by an investment plan. These levels are designed to align with how much risk an investor is willing to take and what kind of returns they’re looking for.
As time goes on, the performance of the market can shift asset allocations because the values of the assets change. Rebalancing means that you periodically buy or sell assets in your portfolio to restore and keep that original desired asset allocation level.
For example, imagine a portfolio that initially targets a 50% allocation in stocks and 50% in bonds. If the stock prices go up during a certain time frame, their increased value might push their allocation up to around 70%. In this case, the investor might choose to sell some stocks and purchase bonds to bring the percentages back to that original 50%-50% target.
How Rebalancing Works
Portfolio rebalancing is all about shielding investors from unwanted risks while still allowing for potential rewards. It also helps keep a portfolio’s focus within the expertise of the portfolio manager.
Sometimes, the price movements of stocks can be way more volatile than those of bonds. So, it’s important to regularly check the percentage of equity-related assets in a portfolio as market conditions shift. If the value of stocks in a portfolio pushes the stock allocation above its target percentage, it might be time to rebalance. This would mean selling off some stock shares to bring down the overall equity percentage in the portfolio.
Investors might also want to tweak their overall portfolio risk to align with their changing financial situations. For example, if an investor is looking for higher returns, they might boost their allocation to riskier assets like stocks. On the flip side, if generating income becomes a bigger priority, they could increase their bond allocation.
Some investors might get the wrong idea about rebalancing, thinking it’s just about spreading assets evenly. But you don’t have to stick to a strict 50%-50% stock and bond split. A portfolio could easily target 70% stocks and 30% bonds, 40% stocks and 60% bonds, or even 10% cash, 40% stocks, and 50% bonds. The right allocation really depends on what the investor wants and needs.
Pros and Cons
Pros
- Rebalancing helps keep investors’ portfolios in line with their risk tolerance and the returns they need.
- It sticks to a set asset allocation defined by an investment strategy.
- This method is disciplined and unemotional, which can help lower risk exposure.
- As investors’ financial situations and goals evolve, rebalancing can be adjusted accordingly.
- Both seasoned individual investors and portfolio managers can take care of rebalancing.
Cons
- Rebalancing does come with transaction costs that might cut into net income.
- Selling off securities that have appreciated in value to rebalance could mean missing out on further price increases for those assets.
- To effectively rebalance and manage risk, a solid understanding of investing is necessary.
- Overdoing it with rebalancing can lead to higher costs for investors.
How Often Should I Do?
It really comes down to what your investment goals are, how much risk you’re comfortable with, and your financial situation. For instance, if you’re a long-term investor who likes to buy and hold, you might want to check in with your financial advisor about your allocations once a year to see if it’s time to rebalance. On the other hand, if you have shorter-term goals, you might want to rebalance more often to ensure you’re on the right path to achieving those goals.