As the saying goes in life, to keep your balance you must keep moving. Moving to maintain balance is also an important part of allocating your wealth, as evidenced by investors deploying the rebalancing strategy for their portfolios. But what is portfolio rebalancing? And why is it of benefit to investors?
Portfolio rebalancing is the process of periodically reviewing the asset allocation of a portfolio and adjusting it, to bring it back in line with the original asset allocation. Rebalancing can be done on aset schedule, such as annually or quarterly, or it can be done on an as-needed basis, such as when a certain threshold for deviation from the target allocation is reached.
Let’s use Jacqueline as our example investor. Jacqueline has a target allocation of 60% equities and 40% bonds. In our example, she has seta threshold of reallocation when her portfolio distribution moves by more than5% outside of their desired allocation.
In this example, the value of the equities portion of the portfolio has increased due to strong performance, the portfolio is now overweight in equities (68%) and underweight in bonds (32%), and well over her 5% deviation threshold set. In this case, Jacqueline would either sell some of the equities that have performed well or purchase more bonds to bring the portfolio back to its target asset allocation of 60% equities and 40% bonds.
Rebalancing helps to ensure that a portfolio’s asset mix remains aligned with an investor's risk tolerance and investment goals. Earlier we talked about Jacqueline having to rebalance to ensure she hadn’t become overweight in equities. Equities are generally a riskier investment than t-bonds, so in rebalancing to 60/40 split, she ensures she isn’t getting excessively risky with her investments.
It can also help you have a fluid view on whether you want to stick with your predetermined asset class weighting, or if you want to change it over time. For example, over a 2-year period Jacqueline might see that the equity portion of her portfolio has been significantly outperforming bonds and as such, she wants to reduce her exposure to bonds by 5% and move that weighting into equities. In other words, her appetite for risk has grown in the current market conditions.
Traditionally, rebalancing was left in the hands of a financial advisor who was looking after a set of portfolios (including yours), adjusting on a schedule instructed by you. However, over recent years with the emergence of online brokerages and portfolio analytics tools, investors can actively manage and rebalance portfolios themselves more easily.
With more readily available data, you can actively manage your portfolio and better react to any price movements that may push your portfolio out of your desired asset class make up. Tools like illio can also give you daily data on how the asset allocation is affecting your risk, allowing you to better judge whether your predetermined composition is giving the risk return profile you had hoped to achieve.
Here are some key things to consider when rebalancing your portfolio:
Risk appetite – as highlighted earlier in this article, the main consideration around rebalancing is to maintain a consistent risk profile. By selling appreciating assets and buying depreciating ones, your portfolio will not swing in either direction of becoming too risky or too conservative.
Winners and losers – investors following a rigid rebalancing strategy means that they will be selling assets as they appreciate and buying the ones depreciating to maintain a desired balance. This will mean investors are applying the most touted phrase in investing; buy low, sell high.However, if this is followed too rigidly, investors could find themselves repeatedly selling winners and buying losers just to maintain a certain asset class split (risk profile).
Costly strategy? - Investors may also notice that buying and selling frequently to maintain a balance has increased other costs, as there are often fees associated with these activities, thus eating into returns. Inmost countries there are also capital gain taxes to take into consideration, as selling for a profit will trigger further costs for your portfolio.
In summary, rebalancing will help you maintain the desired level of risk for a portfolio over time, whilst sticking to your investment goals regardless of how the market moves. However, with better analytics tools and more data points, investors can remain fluid with investment choices, and make decisions for their portfolio on more than just simply keeping a rigid asset class weighting. This, done effectively, should help maximise returns.