You’ve been diligently saving and investing for years, and your portfolio has grown nicely. But as time passes, your asset mix starts to get out of balance. That’s because some investments will grow faster than others, causing your original asset allocation to change. If you don’t rebalance your portfolio, you could take on more risk than what you are comfortable. Or, your portfolio might not provide the growth you need to reach your financial goals. Portfolio rebalancing is where you sell some winners and reinvest the proceeds into lagging investments. Rebalancing helps you stay disciplined, buy low and sell high, and maintain your original investment strategy.
What is portfolio rebalancing, and why is it important
Portfolio rebalancing is restoring your investment mix to its original proportions. Rebalancing forces you to “buy low, sell high.” When one asset class in your portfolio outperforms the others, selling some of your investment in that asset class reduces your exposure to it. You then reinvest the proceeds into the other asset classes. The reinvestment has the effect of bringing your portfolio back into balance.
For example, say you initially allocated 60% of your portfolio to stocks and 40% to bonds. After a year in which stocks have done well, your portfolio may now be 70% stocks and 30% bonds. To rebalance, you would sell some of your stock investments and use the proceeds to buy more bonds, getting your portfolio back to its original 60/40 split.
Rebalancing has several benefits. First, it helps to control risk by ensuring that no one asset class becomes too large a part of your portfolio. Second, it helps improve returns by forcing you to sell assets that have become overvalued and buy assets that have become undervalued. Finally, regular rebalancing can help simplify your investment strategy by keeping you focused on your long-term goals.
Portfolio rebalancing is a crucial element of any successful investing strategy. Regularly restoring your portfolio to its original proportions can help control risk, improve returns, and simplify your investment approach.
How to rebalance your portfolio
If you’re like most people, you probably have a mix of different investments in your portfolio – stocks, bonds, mutual funds, etc. But over time, the composition of your portfolio can change, sometimes quite dramatically. The transformation of your portfolio can happen for various reasons, including changes in the market, your circumstances, or the passage of time. When this happens, it’s important to rebalance your portfolio to make sure that it still meets your goals and objectives. Otherwise, you could take on more risk than you’re comfortable with or miss out on potential gains.
So how do you rebalance your portfolio? The first step is to figure out what your target asset allocation should be. Your target allocation will depend on your circumstances, age, risk tolerance, and investment goals. Once you know your target asset allocation, you can figure out how much of each type of investment you need to own. For example, if you currently have 60% of your money in stocks and 40% in bonds, but your target is 50-50, then you need to sell some of your stock holdings and buy more bonds. You can do this yourself by selling investments above your target allocation and buying investments below your target allocation. Or you can work with a financial advisor who can help you rebalance your portfolio to meet your specific needs and goals.
The benefits of rebalancing your portfolio
When it comes to investing, there’s no one-size-fits-all approach. However, one general principle that all investors should follow is regularly rebalancing their portfolio. By definition, rebalancing is the process of realigning the weightings of your investment assets to maintain your desired level of risk. Rebalancing can help you stay disciplined, buy low and sell high, and improve your long-term returns. For example, let’s say you initially allocated 60% of your portfolio to stocks and 40% to bonds. Over time, your asset allocation will become more skewed toward stocks as the stock market goes up. If you’re still comfortable with that level of risk, then no action is necessary. However, if you want to reduce your exposure to stocks and bring your portfolio back into balance, you need to sell some of your stock holdings and use the proceeds to buy more bonds. While there’s no perfect formula for rebalancing, most experts recommend doing it at least once yearly. So if you haven’t reviewed your portfolio recently, now might be a good time to take a closer look and ensure it’s still aligned with your goals.
Examples of when you should consider rebalancing your portfolio
A portfolio rebalance is when you shift the percentages of assets in your investment mix back to their original targets. You generally rebalance when an asset class has moved a long way from its target, either up or down. Rebalancing forces you to “sell high” and “buy low.” That may sound like market timing, but it’s not. The key is to have predetermined targets for each asset class, so you’re buying and selling based on your own goals and risk tolerance instead of trying to time the market. Rebalancing also keeps your portfolio focused on your goals. Over time, your asset mix will inevitably drift away from its original allocation due to different rates of return among asset classes. Rebalancing gets things back on track.
There are three main times when you should consider rebalancing your portfolio:
- When your asset allocation gets out of whack;
- When you experience a significant life event; and
- When there’s a major market shift.
Let’s take a closer look at each one:
1) If your asset allocation gets out of whack, it’s time to rebalance. For example, let’s say you have a target allocation of 60% stocks and 40% bonds. But after a strong run in the stock market, your portfolio is now 70% stocks and 30% bonds. To return to your original allocation, you need to sell some stocks and use the proceeds to purchase more bonds. Of course, you don’t want to do this too frequently because every time you sell and buy, there are transaction costs involved.
2) A significant life event is another reason to rebalance your portfolio. For example, your financial goals and risk tolerance will likely change if you retire or have a child heading off to college. As a result, you’ll need to adjust your asset mix accordingly.
3)Finally, a significant market shift is another good time to consider rebalancing. For example, let’s say the stock market has taken a big hit and is now down 20%. Meanwhile, bonds have held steady. As a result, your portfolio is much more heavily weighted toward stocks than before (assuming you didn’t sell any during the downturn). This imbalance would be an excellent time to trim back on stocks and increase your bond holdings.
By rebalancing, you can help keep your portfolio focused on your long-term goals and reduce your risk exposure when markets are volatile.
The risks associated with not rebalancing your portfolio
Investors often make the mistake of not rebalancing their portfolios regularly. This lack of consistency can be costly, leading to your portfolio becoming overweight in certain assets or sectors. Over time, this can have a significant impact on your returns. It can also expose you to greater risk if the markets experience a sudden downturn. Rebalancing forces you to sell assets that have gone up in value and buy those that have fallen, which helps to minimize your losses. It also helps to ensure that your portfolio remains diversified, which is critical for long-term success. While some short-term discomfort may be associated with rebalancing, it is generally well worth it in the long run.
Tips for staying on track with portfolio rebalancing
For many investors, staying disciplined is the most challenging part of portfolio rebalancing. It can be tempting to sell winners and buy more of the assets that have been lagging, but this can be a recipe for disaster. Instead, investors should focus on buying low and selling high, which can be difficult when emotions are involved. One way to stay disciplined is to set up alerts that remind you when it’s time to rebalance. An alert system could include setting up a calendar reminder or signing up for an automated rebalancing service. Another way to stay disciplined is to keep your long-term goals in mind. Remember that rebalancing is designed to protect your portfolio from volatility, so resist the urge to make short-term changes that could jeopardize your long-term prospects. By following these tips, you can ensure that you stay on track with your portfolio rebalancing strategy.
Summary
Portfolio rebalancing is essential to help you stay on track with your financial goals and manage risk. By regularly evaluating your asset allocation and rebalancing as needed, you can ensure that your portfolio remains well-diversified and continues to align with your investment objectives. If you need help getting started or staying on track with rebalancing, our team at Stalwart Financial Planning would be happy to assist you. Give us a call today!
Author
Isaac is a Fee-Only (no products sold) Certified Financial Planner® Practitioner. Isaac founded Stalwart Financial Planning with offices in Fayetteville NC and Durham NC. Isaac provides comprehensive planning and investment management services to individuals from all walks of life. Isaac can be reached by phone at 910-867-8464, or by email (iallen@StalwartPlanning.com). Visit him at Stawart Financial Planning www.StalwartPlanning.com.