What is Rebalancing?
Rebalancing is the act of adjusting the asset allocation of your portfolio to target a desired asset allocation.
By rebalancing, you can maintain an investor's risk exposure to which he or she is accustomed. An investor's asset allocation may change as a result of investment choices, market conditions, or unexpected events.
In either case, reallocating your assets back to your target allocation will give you a more well-diversified portfolio.
The act of rebalancing can also be called “re-indexing” or “re-weighting.”
Rebalancing also has a psychological benefit. When markets are not active, investment allocations tend to grow or shrink as a function of performance.
As a result, winners get larger and losers get smaller.
The appearance of “hot” and “cold” sectors becomes exaggerated and makes it seem more difficult to maintain a consistent asset allocation. So, for example, it may seem more difficult to keep a portfolio 50% US equities and 50% non-US equities when the US market is doing well.
The Risks of Not Rebalancing Your Portfolio
Rebalancing is a slightly contrived term for what happens when you take a percentage of your portfolio and change it to improve the overall condition of your investment mix. Let’s say your portfolio contains stocks, bonds and gold and you feel that stocks are too high; you’ll sell off some of your stocks and buy more bonds and gold. The opposite is also true; if stocks are too low, you’ll sell off some of the bonds and gold and buy into stocks.
Why is rebalancing important?
Most of the time, your portfolio will have some sort of asset weighting, such as 60% stocks and 40% bonds and gold. If all goes well during a particular year, your stock will soar and your bonds and gold will flounder. For example, maybe the S&P 500 increased by 10% and a gold ETF fell by 2%. In this case, it would make sense for your stocks to increase by a greater percentage so that your portfolio remains 60% stocks, and sell your underperforming bonds and gold so that you can buy other underperforming assets or take your profits.
One of the reasons why you should take an active interest in rebalancing your portfolio is because of how well it performs in the long run. When you keep to your asset allocation, you’ll see the better results over time.
How to Update Your Portfolio
There are two ways of counterbalancing your portfolio. One way is to shift the allocated percentage (say, from 40% stocks to 30% stocks), while the second way is to sell some stocks and buy a contrarian stock.
You may ask yourself whether it's better to shift the stocks or rebalance. In our opinion, both of them have their own advantages and disadvantages.
The updating technique has an advantage over rebalancing because you can just update your portfolio as required. This minimizes the transaction cost of your portfolio. There is no need to sell and buy stocks, as you can shift the percentage of your portfolio to whatever level you want.
However, there is also a disadvantage of this technique. Shifting your portfolio's percentage from one stock to another has negative effects on the market. For instance, if you want to increase your percentage in Apple from 40% to 50%, you will need to sell Apple stock to buy more stocks in another company, or you will need to sell Apple stock and buy other stocks in the same time period. Either way, Apple’s net worth will decrease. As a result, the stock price of Apple might decrease as well. Therefore, rebalancing is considered to have positive effects on overall stock market.
How Frequently Should You Rebalance?
To control risk, you need to rebalance. There are no absolutely right or wrong times to rebalance your portfolio, but some rebalancing strategies suggest you do so once a year. Make your own plan, but always have a plan in place before you make any big moves.
Investment Tools That Rebalance For You
These tools simply set aside a certain amount of money at regular intervals and automatically invest it wherever the stock market falls…….…. this means that the investor can stay on their regular buying schedule, waiting for a predetermined price to buy stocks or bonds, without needing to rebalance their portfolio again.
Many are designed to rebalance your portfolio only if prices rise or fall by more than a set amount. This takes the human emotions of fear and greed out of the equation by preventing you from rebalancing after a big market dip and the pullback that follows.
These systems are rebalancing to the level of risk that the investor is comfortable with. If you think there is a lot of risk, they do not expose you to more risk than you want to take. If you think there is a lot of risk, they do not expose you to more risk than you want to take.
An investor can choose the degree of risk he or she wants to take. You can take less risk and let a portfolio manage without having to put money into it all the time or you can take more risk and have to put money in it more often.
Even though your investments will come regularly, they will come after some steep gains for the market and you may have to put money in when the market is too high.