The buying or selling of assets to restore your portfolio to your original target allocation is an important step in controlling risk. Although it sounds logical in practice it can often feel counterintuitive. This is because rebalancing requires you to sell assets that are performing well and buy assets that are not doing so well currently. It is easier to come to terms with if you think of it as taking profits from your “winners” and using the profits to buy other assets whose day has yet to come.
The initial step, as always, is picking a strategic asset allocation plan that matches your risk profile, your investment goals and your time horizon.
Rebalancing is not to be confused with reallocation.
• Rebalancing is adjusting your portfolio through time to keep it in line with your risk profile. For example, say you have a risk profile, with an asset allocation of 60% equities, 25% fixed interest and 15% property. If the out-performance of your equity investments pushed that mix to 80% equities, you might sell some equity funds and buy some fixed interest funds to bring those percentages back in line with your attitude to risk.
• Reallocation is shifting to a new asset allocation that reflects an entirely different risk profile. For example, an investor in their 30s may prefer an aggressive asset allocation with 90% equity based funds. But by the time they retire, they may switch to a more conservative approach with only 40% equity based funds.
Creating an initial risk profile, asset allocation and investment plan is only the first step in an investment process that develops over time. A successful plan requires regular maintenance in order to achieve the desired results. Rebalancing is a key form of maintenance.
Going against Human nature:
In rising stock markets, people often take on more risk than they’re suited for, often ending up with a larger percentage of riskier investments in their portfolios than their risk profile warrants. This can be simply due to market actions alone. Many assume that the upward performance trend will continue indefinitely (the technology bubble in the late ’90’s for example), When the markets do fall their losses are far higher than they should have been. By the time they realise they have taken on too much risk it is usually too late. Often they finally sell after experiencing substantial declines in investment value, having bought high and sold low, contrary to all conventional wisdom.
If you don’t have a disciplined rebalancing plan, you are letting the market dictate the risk level of your portfolio. A regular rebalancing plan helps instil discipline in the investment process and in most cases, a rebalanced portfolio has lower risk and similar to slightly higher returns
Reduced risk and improved return is obviously a good combination, and it’s due to the contrarian nature of rebalancing. When you rebalance, you sell some of the asset classes that have performed well and move to asset classes that haven’t done so well. In other words, you regularly buy low and sell high.
You can also use rebalancing to make use of tax breaks, for example selling profitable investment to use up capital gains tax allowance. Any additional new savings should be targeted at asset categories that have fallen behind. Another option is to receive dividend and capital gain distributions in cash and channel them toward underweight asset classes. These strategies can help you get gradually back up to your target allocations without incurring fees and/or taxes on the sales of your investments.
How often should you rebalance?
Some people rebalance on a certain time-based schedule – for example, once every 6 months, every year, or every 2 years. Others wait until certain asset classes shift a certain amount away from their desired targets before taking any action. There is no clear agreement on the answer to this question, and many “experts” contradict each other. Although based on sound principles, rebalancing is an art rather than a science.
Since it seems that there is no concrete right answer, the most important thing is to just make sure you set up some way to rebalance that does not involve emotions or market timing.