This is part five of a series on investing in a volatile market. Click here for part one on creating a financial roadmap; click here for part two on evaluating your risk tolerance; click here for part three on diversifying using a risk pyramid; and click here for part four on dollar cost averaging.
Portfolio rebalancing is an important part of the investing process, whether or not the markets are particularly volatile. As the markets change over time, some assets go up while others go down. As a result, your allocations shift because positions which have done well will make up larger and larger parts of the portfolio while those that have struggled will begin to shrink.
Rebalancing basically just means readjusting your portfolio so that your asset allocation is where you want or need it to be. Many experts, including the Securities and Exchange Commission, advise doing this on a regular basis, whether that's once a year or once every six months. If you don't want to rebalance based on the calendar, the SEC also suggests rebalancing based on your investments instead of the calendar.
One benefit of portfolio rebalancing is that it forces you to buy low and sell high. Many investors who make their own investment decisions find themselves buying more of a stock when it goes up and selling when it goes down, but that practice causes portfolios to underperform. By rebalancing your portfolio every six or 12 months, you buy more of the assets that fell and sell those that increased. If your portfolio is adequately diversified, then rebalancing it on a regular basis will cause you to buy more investments while they are lower while selling them after they have gained money.
Here's an example of how portfolio rebalancing works. If you decided that stocks should make up 60% of your portfolio, you probably have found in recent years that stocks have increased so much that this part of your portfolio has increased. Stocks may even make up 80% of your portfolio now, which means your diversification is down, and it's time to sell some stocks and buy some other assets.
There are three different ways you can rebalance your portfolio.
- You can sell investments from asset classes that now take up too large of a percentage of your portfolio and then use the proceeds from those sales to purchase assets in other classes. For example, you can sell some stocks to take your stock allocation down from 80% to 60% and then use the proceeds to purchase bonds or other asset classes, keeping in mind your desired allocation as you make your purchases.
- If you don't want to sell any stocks, then you could simply add money to your portfolio and use it to buy any asset classes that are under-weighted.
- If you've been following a dollar cost averaging strategy and adding money to your portfolio on a regular basis, you can also adjust your contributions to earmark a larger percentage of your contributions to under-weighted asset classes to bring your portfolio allocation back where you need it to be.
It may be a good idea to use some combination of all three of these strategies to rebalance your portfolio. Don't forget to take into account any transaction fees and the tax consequences before making any trades.
As you work to rebalance the asset mix so your allocation is at the correct percentages, you will also want to examine each of the investments within each category. For example, it may be time to switch out which stocks or bonds you own.
This article first appeared on ValueWalk Premium