Rebalancing your investment portfolio: why, when and how

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We know that the true nature of the market is volatility.

We can’t expect a 100% guaranteed return when we’re just “buying and holding” stocks.

This is why the main objective of portfolio rebalancing is to have better risk control and to hedge your investments. This can be achieved by ensuring that the investment portfolio is not overly dependent on any particular asset class.

Rebalancing is an important part of long-term investing.

At least once every few months, you should compare your investment portfolio to your ideal asset allocation – the right mix of stocks, bonds, cash, or other investments for your investment goals. Then make changes by selling and buying shares of investments to realign your portfolio to the desired target.

Therefore, rebalancing can be viewed as a risk management strategy that helps investors align their investments based on risk tolerance and investment goals. There are several ways to do this, for example, by raising/lowering any existing investment or adding a new asset class.

It may seem very attractive to sell an investment that has outperformed, but remember that past performance does not guarantee future results.

Let’s think about this more specifically and consider:

  • Invested $15,000 in a mutual fund of ABC Company and XYZ Company in January 2018. On July 1, 2021, investment increases by $10,000.
  • Company ABC’s mutual fund has a return of $8,000 while the other fund has generated $2,000.
  • The current portfolio weighting ratio for ABC:XYZ is 80%:20%

At first glance, this seems like an excellent return on investment for 2.5 years.

However, in the coming months, there might be a scenario where ABC might not deliver those huge returns. On the other hand, there could be an uptrend for XYZ Mutual Fund. In this scenario, the best thing we can do is rebalance the portfolio to take some of the profits from ABC and invest in XYZ or invest in any other asset class (bonds, real estate, futures).

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The most common steps any private investor can take to rebalance their portfolio:

  1. Asset allocation plan at your fingertips. The parameters must be taken into account: monthly and annual income, financial objectives, time, etc.
  2. Evaluate current asset allocation towards stocks, bonds, savings, etc. After checking and mapping, it is necessary to carry out a comparative analysis of the assets – their current situation in the market, their profitability, their forecasts, etc. and deciding which securities to keep, add or remove from the investment portfolio.
  3. Pay attention to taxes. Remember that holding stocks for more than a year is considered long-term capital and may be taxed differently depending on the type of security and financial institutions.
  4. Last but not least, rebalancing also means reviewing an investment portfolio from time to timelike 6 months, to assess the position and make changes if necessary.

Suppose you rebalance your portfolio from time to time. In this case, it is very likely that it will become heavily weighted in equities in a bull market.

The critical problem with this is, for example, in retirement, you may not want to be able to ride out the next bear market. You want to keep a large percentage of the entire portfolio in a safer portfolio than you had in your youth. Therefore, during a bear market, you can rebalance the % you hold in cash, bonds, stocks, etc. directing new money to securities like stocks that have fallen below your preferred %. Usually it’s around 5% and above.

If you like to hold 70% of the portfolio in stocks, but it’s a bear market. Your equity holdings have dropped to 65% of the investment portfolio holdings. You would funnel new money into stocks until you hit 70%. If your stocks represent 90% of your portfolio due to a bull market, you will use new money in cash equivalents, real estate, bonds or other non-stocks to rebalance the %.

The idea is to manage all types of financial risk, from inflation to taxation to the roller coaster of the market, to reduce the frequency of unpleasant setbacks during your retirement because it is a time of life that has less flexibility to deal with setbacks.

Portfolio rebalancing is an essential skill for any investor!

This should be done periodically depending on the financial health and objectives of the investors. It’s about making informed, risk-aware choices that are appropriate for an investment portfolio at any given time.

The rebalancing trade-off can be expensive and you have to incur fees to transfer money between asset classes. Thus, you need to consider these costs when deciding to rebalance. Due to the effect of taxation, rebalancing of taxable accounts should only be done through new cash inflows to buy underweight assets and avoid selling appreciated assets.

The 25/5 rule is a good rule of thumb:

Rebalance when the asset deviates by more than 25% from its assigned allocation, or 5% absolute of the overall portfolio.

For example, if you have a 50/40/10 in stocks, ETFs and bonds, you rebalance when stocks become 55% (triggering of the 5% absolute rule) or that ETFs become 45% (5% rule), or bonds become 12.5% ​​(25% rule).

Review and rebalance portfolios to respond to changes, either in one’s own circumstances or in the economic environment. If you don’t, you still accept an average performance across your entire portfolio.

Frequency is not the key. The lack of balance is the key.

Adjust your portfolio when it becomes too biased. This means that you need tolerances for market movements.

If you keep it for the long term (“buy and hold”), annually, if your rebalancing is high, otherwise quarterly is generally recommended.

Investing by formula may work for some people, but it’s not hard to do better than average performance.

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