After that you have created a portfolio of best-of-breed stocks and diversified it even more with a few other asset classes, you can lay back and never have to worry about it again. Very Wrong! Just as checking on your investments everyday can lead to problems, never taking the time to review your progress can be equally bad. Taking the time to rebalance on a regular basis can help to make sure your portfolio does not stray from its intent and you are able to meet your financial goals.
It’s all about diversification and risk
Rebalancing is the process of reallocating your portfolio back to your strategic targets or to cheaper assets and stocks. It can be done within your stock portfolio, rebalancing the selection of industries and sectors, or across all your investments by rebalancing the proportion of assets like stocks, real estate and bonds.
There are a couple of reasons why you should regularly rebalancing your investments. First, it helps to adjust your portfolio to less expensive investments that might be ready to rebound. If stocks of healthcare companies have had a bad year while technology stocks have soared, then you would be well-served to sell off some of the relatively expensive tech stocks and put the money into healthcare.
I is important to note that rebalancing helps to make sure that your portfolio is not overly exposed to any one asset or sector. Remember that a well-balanced, diversified portfolio will have less risk because losses in any one asset or group will not affect the total value as much. You can still earn a solid return and avoid the market crashes that often happen in one group of investments.
For instance, if you had invested in a diversified portfolio of stocks in 1995, by the year 2000 that portfolio would be heavily weighted to technology stocks because the values had grown so much faster than other sectors during the tech boom. The Nasdaq index of technology companies surged more than five-fold in the five years to the new millennium against a relatively slower doubling in the S&P500 index. Unfortunately, investors that failed to rebalance the risks in their portfolio saw their tech shares fall just as quickly. By the time the tech bubble fully deflated in 2002, the Nasdaq index had lost almost 78% of its value while the S&P500 had fallen by just 25% from its height.
The concept works across asset classes as well. Twice over the two decades, investors have seen stocks soar. If left unchecked, the proportion of their portfolio in stocks would have grown much larger than that invested in other assets like bonds and real estate. By rebalancing, investors took money out of riskier stocks to reallocate to less risky assets.
Two ways to rebalance
Investors typically rebalance their portfolio in one of two ways, annually or by percentage-of-portfolio. Annual rebalancing, or another time-delimited schedule, is done every year around. Percentage-of-portfolio rebalancing sets percentages of the portfolio value for each asset class and sector to which the investor wants to keep. The investor rebalances the investments when the percentages vary too much from the targets.
Annual rebalancing is fairly straight-forward. Many investors rebalance in December but there are reasons you may want to do your rebalancing in January. If you sell your winning investments in December, then capital gains taxes are due almost immediately the next year. If you wait until January, then taxes won’t be due until the following year. One disadvantage to annual rebalancing is that it is an arbitrary system and has no real theoretical backing. If the value of the assets or sectors in your portfolio have not varied much from their target weights then it doesn’t really make much sense to incur transaction costs or taxes in rebalancing. The benefit to annual, or even less frequent rebalancing, it is much easier to manage. You do not have to constantly check your portfolio for percentage weights which could lead to over-trading.
The percentage-of-portfolio method requires more management but is a little more theoretically sound. You are rebalancing because you do not want your portfolio overly exposed to any one asset or group, so it would stand to reason that you would want to rebalance on the percentages within the portfolio. The method can be more costly than annual rebalancing depending on how quickly the portfolio percentages change.
To reduce the constant monitoring and higher costs on a percentage-of-portfolio method, many investors set ranges around their percentage targets. For example, if you want 50% of your portfolio in stocks then you might set a range of between 40% and 60% to be acceptable. As long as the value of your stocks, as a percentage of your portfolio, was between the range then you would not need to rebalance.
Whatever method of rebalancing you choose, it is a good idea to regularly assess the risk in your portfolio. While a portfolio full of high-growth stocks and potentially high returns might sound enticing, just think of the dilemma you could face when stock prices fall by 50% or better. A diversified portfolio of different assets and sectors will help to minimize risk and provide the return you need to meet your financial tragets.