Rebalancing Your Portfolio: Stay on Track to Investment Goals

What does “rebalancing” a portfolio mean and why is it done?

Imagine your investment portfolio as a carefully balanced recipe for financial success. You started with a specific mix of ingredients – stocks, bonds, and perhaps other assets – chosen to match your risk tolerance and long-term goals. But just like any recipe, the proportions can shift over time. That’s where “rebalancing” comes in.

Rebalancing your portfolio is the process of periodically adjusting your asset allocation to bring it back to your original target mix. Think of it as fine-tuning your investment recipe. Over time, different asset classes will perform differently. For example, stocks might surge while bonds remain relatively flat. This differential performance naturally alters the initial balance you set. If your initial plan was to have 60% of your portfolio in stocks and 40% in bonds, a strong stock market could push your stock allocation up to 70% or even higher, while your bond allocation shrinks proportionally.

So, why bother rebalancing? The core reason is to manage risk and maintain alignment with your long-term financial objectives. When your portfolio drifts away from your target allocation, it can inadvertently increase your overall risk level. Let’s revisit the 60/40 example. If your stock allocation grows to 70%, you are now taking on more stock market risk than you initially intended. While higher risk can potentially lead to higher returns, it also means greater potential for losses, especially during market downturns. Rebalancing helps to control this risk creep by selling some of the assets that have performed well (in our example, stocks) and using the proceeds to buy assets that have underperformed (bonds). This action essentially “locks in” some profits from the outperforming asset class and buys into the potentially undervalued asset class.

Furthermore, rebalancing can be seen as a disciplined approach to “buying low and selling high,” a fundamental principle of sound investing. When you rebalance, you are systematically selling assets that have become relatively expensive (because their value has increased) and buying assets that have become relatively cheaper (because their value has lagged). This disciplined approach can help you avoid the emotional pitfalls of investing, such as chasing market trends or panicking during downturns. Instead of letting emotions dictate your investment decisions, rebalancing provides a structured and rational framework.

The frequency of rebalancing is a common question. There’s no single “right” answer, and it often depends on individual preferences and portfolio characteristics. Some investors choose to rebalance on a time-based schedule, such as annually, semi-annually, or even quarterly. Others prefer a threshold-based approach, rebalancing only when their asset allocation drifts outside of a predetermined range. For example, you might decide to rebalance only when your stock allocation deviates by more than 5% from your target of 60%. Both approaches have their merits. Time-based rebalancing provides a consistent and predictable schedule. Threshold-based rebalancing can be more efficient, triggering adjustments only when necessary and potentially reducing transaction costs if you are using commission-based trading.

In conclusion, rebalancing is a crucial portfolio management strategy for intermediate investors and beyond. It’s not about market timing or trying to predict the next big winner. Instead, it’s a disciplined process designed to keep your portfolio aligned with your intended risk level and long-term financial goals. By regularly rebalancing, you are actively managing risk, potentially enhancing returns through a “buy low, sell high” strategy, and staying committed to your investment plan, even as market conditions fluctuate. Think of rebalancing as regular maintenance for your financial engine, ensuring it continues to run smoothly and efficiently towards your desired destination.