It’s one of the most overlooked parts of an investing strategy…
But what most don’t realise is that diversification is just the beginning. If you’re not rebalancing your portfolio on a regular basis, you could risking your wealth.
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Why you need to rebalance
Picture a portfolio where 50 percent is invested in stocks, 30 percent is in bonds, 10 percent is in real estate and the rest is in cash.
Now imagine that over the next 12 months, stock markets go gangbusters and are up 20 percent – while bond markets plod along and earn you 2 percent. Because of this big difference in performance, stocks now make up a larger proportion of your portfolio than before.
In other words, the portfolio is now less diversified – and more at risk.
That’s because significantly more of the portfolio is now invested in one asset class than originally intended. So if the stock market crashes it will have a bigger effect on your portfolio.
Left unchecked, a diversified portfolio can become unbalanced through performance. And it can happen without investors even realising.
That’s because, over time, higher-return (and higher risk) assets can increase their share and asset allocations can “drift” to the point where investors are more exposed to one particular stock or asset class than when the portfolio was set up.
Let’s take a look at this in action. The charts below show what happened to a real-life portfolio that started with a 60/40 allocation to U.S. stocks and bonds. This is a generic, one-size-fits-all approach to diversification, and a simple way of looking at how this works.
From 1997 to 2007, stocks in the U.S. rallied. So left unchecked, the equity segment of the portfolio increased to 65 percent stocks, while fixed income fell to 35 percent over the 10 years.
That means a bigger part of the portfolio was invested in stocks by 2007. So when stock markets around the world crashed in 2008 and 2009, the portfolio suffered more than it would have if stocks had been (as originally intended) just 60 percent of the portfolio. And, left unchecked, the collapse caused the portfolio’s allocation of stocks to fall to around 48 percent by March 2009. Meanwhile, its allocation of fixed income increased to 52 percent.
Then, from March 2009 to 2016, stocks soared. But because the portfolio was underinvested in stocks during this time (with just 48 percent in stocks instead of 60 percent), the investor missed out on some big potential gains.
But still, because of this rally, the portfolio now has a big percentage of stocks again. So if another crash happens, it will suffer.
How to rebalance
By simply rebalancing this portfolio on a regular basis, the investor could have avoided some big losses and made bigger gains.
Now, rebalancing just means realigning the portion of each asset in a portfolio. In other words, selling “winning” assets that have increased their share of the portfolio since it was first created – and replacing them with other assets to balance out the risk.
The point is to make sure a portfolio isn’t too dependent on the success (or failure) of one particular stock, asset class or market.
Imagine a particular stock has performed well and increased its share of your portfolio. That’s good news – but now you’re more at risk if that stock falls because more of your portfolio is invested in it.
So to reduce the level of risk you just need to sell some of those equities and invest in other stocks. Now you’re back where you started.
Deciding when and how to rebalance is different for each individual investor. There’s no “one size fits all” solution. Different strategies work for different people.
How to keep your portfolio’s balance
But there are three basic strategies to keep a portfolio in check:
- Time: a portfolio is rebalanced after a specific period… once every six months or year, for example. Most passive investors use “calendar rebalancing” – checking their asset allocations on an annual basis to make sure it still meets their investment goals and appetite for risk.
- Threshold: investors set a limit, similar to a stop-loss level, to prevent one asset drifting too far from its original allocation and rebalance once it reaches this limit (five percent on either side of the target, for example).
- Time and threshold: as the name suggests, this is a combination of the first two strategies. The portfolio is checked at regular intervals, but isn’t rebalanced unless one of the assets has reached its predetermined threshold.
Of course, rebalancing involves the usual brokerage costs and trading fees, so it’s important to remember this when deciding how often to rebalance.
Trim the fat
Rebalancing protects investors from emotions that can lead to bad financial decisions (as we’ve written before). If one asset performed well last time, we tend to think it’s going to perform well next time too (that’s known as “status quo” bias).
But all good things must come to an end… and investors who are overweight a particular stock or asset class are in for a bad fall when it does.
Selling “winning” stocks and rebalancing or trading them for other, cheaper assets means investors are well positioned to profit from growing markets at lower prices.
In short, rebalancing helps you make the most of diversification.