Rebalancing

Rebalancing is when one adjusts the weightings of a portfolio as investment values change to maintain the original asset allocation.  Rebalancing can present an opportunity to sell high and buy low, taking the gains from high-performing investments and reinvesting them in areas that have not yet capitalized on potential growth.

For example, say an original asset allocation was 50% stocks and 50% bonds. If the stocks performed well during the period, it could have increased the stock weighting of the portfolio to 70%. You may then decide to sell of your stock holdings and buy bonds to get the portfolio back to the original target allocation of 50% /50%.

Rebalancing can Reduce Risk

Portfolio rebalancing safeguards you from being overly exposed to undesirable risk.  If you do not rebalance your portfolio, your asset allocation will shift, and you may no longer be invested according to your risk tolerance therefore, becoming either too aggressive or not aggressive enough. 

If one asset class starts to make up too much of your portfolio, it means you have too many eggs in one basket. If that asset starts going down, a bigger portion then the risk you are looking to take in your portfolio will fall.  Likewise, if an asset class performs poorly and starts to make up less of your portfolio, you might not have enough exposure in that area when this part of your portfolio starts to do well and might miss out on upside.

Rebalancing can be Difficult to Execute

It typically feels counterintuitive to sell your best performing asset classes to buy more of the conservative asset class.  The common belief amongst a large majority of investors is if an asset class did well this year, the next year should be the same and they therefore, remain heavily invested in last year’s high performing funds and sell the underperforming funds altering the asset weight that was originally chosen based on desired risk level.

Because markets tend to work in cycles, it is likely that the underperforming assets will eventually be back in favor and may provide a good opportunity.  This is the classic scenario of buy low, sell high.

Calendar rebalancing is the simplest rebalancing approach. This strategy simply involves analyzing the investment holdings within the portfolio at predetermined time intervals and adjusting to the original allocation at a desired frequency. Monthly, quarterly, and annual rebalancing are common strategies used.

A more responsive approach to rebalancing is the allowable percentage composition of an asset in a portfolio – this is known as a constant-mix strategy with bands.

For Example, say that an asset class moves 5% from the targeted allocation we would then make the necessary rebalancing adjustment.  This can happen at anytime during the year and of course requires more attention to portfolio changes.

How often should I Rebalance my portfolio

Commonly quarterly is sufficient for typical investors.  But the optimal frequency of portfolio rebalancing is different for every individual.  You should take into consideration your cash flow needs, costs, preferences, and tax considerations, including what type of account that you are selling from and whether your rebalancing creates capital gains or losses. These considerations should be measured in relation to the benefits of rebalancing.  Please also be aware that rebalancing can potentially trigger tax consequences when done in taxable accounts (i.e., outside of IRAs, 401k s, or other retirement plans).  As always, please check with your financial and tax advisor prior to instituting any rebalancing strategy.

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