What is Portfolio Rebalancing and why it matters?
Robust portfolio management has two essential processes.
- Right Asset Allocation based on your financial goals, investment horizon, and risk tolerance
- Periodic Review and Portfolio Rebalancing
What Is Asset Allocation?
An efficient Asset allocation strategy aims to put together different asset classes in a portfolio to grow wealth and diversify risk.
You can achieve efficient diversification by investing in assets that are not correlated—implying that they don't move up or down simultaneously. When the value of one asset goes up, the other's value goes down, and vice-versa, meaning they are non-correlated.
For Example - Stocks and Bonds. Typically, when stocks' value goes up, bonds' value tends to go down and vice-versa.
By owning two or more non-correlated assets, you can protect your portfolio from extreme volatility.
What is Portfolio Rebalancing?
It is a process whereby you sell a specific portion of the assets that have gone up in value to buy assets that have gone down in value.
This is the most crucial but generally overlooked component of portfolio management. Neglecting this process is one of the most important reasons why many investors cannot grow long-term wealth, despite experiencing steep growth during bull markets.
Why is rebalancing necessary?
- It helps you maintain the initially defined asset allocation. When the markets move up as they did in 2020, portfolio rebalancing would have ensured that a 70:30 Stock/Bond portfolio did not drift towards 90:10 or more Stock/Bond allocation.
Similarly, when the equities crashed in January 2018, it would have helped you ensure that the bond allocation did not exceed initially defined ratios.
- It helps you lock in profits. We all know that all asset classes have cycles; they keep going up or down in response to different stimuli. Regular rebalancing of your portfolio can help you book profits from assets that are doing well at present but could go down if the markets are no longer conducive.
You can see from this graph that the gold price has been very volatile. It is a classic example of where regular portfolio rebalancing could have protected investor wealth while creating value, which otherwise could have resulted in a loss or flat returns.
- Disciplined rebalancing automates the Buy Low - Sell High procedure, adding consistent growth to your portfolio.
- Avoiding Herd Mentality - An urge to do what everyone else is doing, ie., typically selling assets that are underperforming and buying assets that are performing well. Such action can be counterproductive to the overall positive performance of the portfolio.
- Personal Bias – Investors tend to build emotional bonding/dislike with a particular type of asset and keep accumulating it or avoiding it without reasoning its position in the portfolio
How to Rebalance a Portfolio?
There are two basic approaches to portfolio rebalancing;
- Periodic Rebalancing
- Target Based Rebalancing
With Periodic Rebalancing, the portfolio is reviewed, and the holdings are restored to the target allocation at regular intervals (monthly, quarterly, or annually).
Target Based Rebalancing is executed whenever any asset class within the portfolio varies beyond a predetermined target level (for example, +/-10%).
Disadvantages of Portfolio Rebalancing
- Transaction Costs - Frequent rebalancing can substantially increase transaction costs, mainly if the brokerage fees are high
- Tax Implications - Investors have to be aware of the Capital-gains tax if applicable
- Target Based Rebalancing requires more expensive monitoring of the portfolio and greater adherence to discipline.
Summary and Expert Help
- Efficient portfolio construction, regular reviews and rebalancing are vital for growing wealth and protecting risk
- Rebalancing is the most useful and straightforward way to keep a portfolio on track
- Periodic and Target Based are commonly used rebalancing strategies
- Investors who begin with efficient asset allocation but neglect to rebalance are far less likely to achieve their investment goals than those who do.
- Half Yearly and or Target-based rebalancing of +/-5% per asset class are reasonable guidelines to balance the cost/reward tradeoffs.
As an Independent Financial Advisor, I can help you create a Holistic financial plan and the Right Asset Allocation.
I can also help you Rebalance your portfolio at regular intervals to ensure that it remains aligned to your goals and risk tolerance.
Arrange a Free Consultation today and jumpstart your journey towards wealth creation.
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