When discussing investment success, one key area where focus is generally placed is on long term investment returns, adjusted for risk. While most investors discuss performance, fewer individuals think about the tools and strategies of how long-term success for your portfolio is achieved.
One of the key success factors for building a sustainable long-term strategy is the practice of portfolio rebalancing.
What is portfolio rebalancing?
Portfolio rebalancing is the process of periodically realigning your portfolio to achieve a desired, predetermined asset mix.
Your investment portfolio asset mix is determined based on several characteristics specific to your financial situation. Some of these are: age, income, risk appetite, and expenses. Working with you, your asset manager will determine a target asset allocation, which is how your portfolio should optimally be balanced between equities (stocks) and fixed income (bonds). Although this is easy to achieve when the assets are initially invested, asset values fluctuate over time, altering the portfolio’s asset mix. When one asset class outperforms the other, the result is a higher than desired weight of that asset class in the overall portfolio. (The importance of asset allocation is discussed in a previous article, which can be found here.)
Consider the following situation: you begin by investing your money in a balanced portfolio with a 60% stocks – 40% bonds asset mix. This is the target asset allocation for your portfolio. Now let’s assume that the stocks in your portfolio outperform bonds and therefore increase in value quicker than the bonds, all else being equal. As a result, your portfolio asset allocation is now 75% stocks – 25% bonds. In order to bring the portfolio back to its target asset mix you’ll need to rebalance by selling a portion of your stocks and using the proceeds to buy bonds. This process restores the portfolio to its target allocation of 60% stocks – 40% bonds.
Portfolio rebalancing and risk management
While rebalancing is easy in theory, it is much harder to apply in practice. Human emotions often get in the way, making rebalancing much more difficult to execute. It’s tough for investors to justify selling an asset class that’s performing well and buying an asset class that’s underperforming, just to get back to the target allocation, all while markets are running up and portfolios are making money. But, this is precisely when one should rebalance. Portfolio rebalancing may seem counterintuitive, however, it supports the “buy low, sell high” investment mantra. A disciplined rebalancing process forces investors to do exactly that: sell the outperforming “expensive” asset and buy the underperforming “cheap” asset. Furthermore, rebalancing ensures portfolios stay well diversified, in addition to locking in profits from investments.
Portfolio rebalancing is one of the tools used for risk management.
Bull markets can increase risk in portfolios for investors twofold: through the equity portion increasing by more, and because investors typically require safer investments as they age. If markets approach a point of correction (a decrease of 10%), portfolios that have higher proportions of equities can typically expect to see a larger decrease in value. Disciplined rebalancing is particularly important for those investors nearing retirement or in retirement.
How often should portfolios be rebalanced?
Rebalancing is a dynamic process, and there is no hard and fast rule regarding how often portfolios should be rebalanced. Typically, ranges of +/- 5% or 10% are set around weights of assets when creating the target asset mix. For example, for the 60% stocks / 40% bonds balanced portfolio you could add ranges around each asset class. If we use 10%, then the acceptable range for stocks is 50% – 70% and the range for bonds is 30% – 50%. These ranges allow the asset allocations to increase (or decrease) giving the portfolio room to benefit from growth in performing investments, without triggering a need to rebalance too frequently.
Rebalancing should occur when assets breach the allowable range around the target. It can be done on a quarterly, semi-annual, or another predetermined timeline.
Asset allocation should always be monitored, especially before extraordinary events that could cause sudden shifts in value. And remember, this is a risk management tool used to keep investors disciplined by removing emotion from the process. By staying true to long term investment objectives, investors can avoid the pitfalls of short-term investing, and have better odds to achieve investment success in their portfolios.