It’s important to rebalance your portfolio on a regular basis in order to maintain optimal investment returns as well as to maintain your optimal exposure to investment risk. When you create a new investment portfolio, you set your target allocations to stocks, bonds, cash, and other investments. As the markets move and the value of your individual investments change, your portfolio will drift from its original allocations.
If stocks outperform bonds, your portfolio will be overexposed to stocks (and, thus, more risk) than you originally intended when designing your portfolio.
How do you solve this problem? You rebalance your portfolio.
What does it mean to rebalance a portfolio?
Rebalancing your portfolio means buying or selling investments to return to your original target allocations.
For example, say you originally allocated 60% of your portfolio to stocks and 40% to bonds. After a year in which the stock market rose while the bond market fell, your portfolio might now be 70% stocks and 30% bonds.
To rebalance, you would sell some of your stock holdings and use the proceeds to buy more bonds, returning your portfolio to its original 60/40 split.
What are the advantages of rebalancing?
There are several advantages to rebalancing your portfolio:
- Rebalancing forces you to buy low and sell high. When you rebalance, you’re selling investments that have increased in value and using the proceeds to buy investments that have declined in value. This buys into the fundamental investing principle of buying low and selling high.
- Rebalancing helps you stay disciplined. Once you’ve rebalanced your portfolio back to its original target allocations, it will require discipline to stick with the plan and not let your portfolio drift again.
- Rebalancing can boost returns and reduce risk. By selling investments that have increased in value and buying investments that have declined in value, rebalancing will boost your returns over the long term.
- Rebalancing can help you control your emotions. When the stock market is down, it’s natural to want to sell and when the stock market is up, it’s natural to want to buy. However, these reactions are usually the wrong thing to do. Rebalancing your portfolio regularly can help you stay disciplined and control your emotions when it comes to investing.
How often should I rebalance my portfolio?
There is no one-size-fits-all answer to this question. The frequency of rebalancing will depend on your investment goals, risk tolerance, and time horizon.
If you have a long time horizon (more than ten years), you can afford to be more aggressive and may only need to rebalance once per year or even less frequently.
If you have a shorter time horizon or are risk-averse, you may need to rebalance more frequently.
The main benefits of rebalancing your portfolio–maintaining the agreed-upon risk profile–can be achieved through nearly any rebalancing strategy and frequency. For most investors, a yearly rebalancing will probably be enough.
For more advanced strategies, it is interesting to look at the results of a study conducted by YCharts. YCharts issued a report looking at how six different rebalancing strategies affected portfolio performance and risk over 25 years of history. While they found that there were differences between the strategies, the differences were minimal. They conclude regularity in rebalancing is more important than the type of rebalancing employed.
Vanguard came to a similar conclusion, arguing that annual or semi-annual monitoring is sufficient.
Key Takeaways
Rebalancing is critical to maintaining appropriate exposure to various asset classes.
Rebalancing should be done on a regular basis
The frequency of rebalancing does not matter that much, but an annual rebalancing appears to produce a reasonable balance between risk control and cost minimization for most investors
