How to Rebalance Your Portfolio

Disclaimer: The content below is for educational and informational purposes only and does not constitute investment advice, personal recommendations, or a solicitation to buy or sell financial instruments. Investing involves risks, including the potential loss of capital. Past performance is not indicative of future results. Investors should consider their individual circumstances and seek independent professional advice where appropriate.

Diversification is the first step to creating a low-risk and resilient investment portfolio in principle, though risk cannot be eliminated. The next step is to rebalance it when you find that some of your investments have fallen and that you didn't diversify enough in the areas that were meant to hold your portfolio together. Rebalancing is a form of portfolio risk management strategy that reduces risk relative to the intended allocation and also helps achieve financial goals over the long term.

It helps you ensure that your portfolio is in line with your goals and risk tolerance at a given point in time. It is an important component of smart investment portfolio management and an easy, efficient instrument of investment risk management when applied consistently. In this blog, we will understand what rebalancing is and how to rebalance investments for educational purposes.

What is Portfolio Rebalancing?

Portfolio rebalancing is the process of adjusting your investments and weights of assets to realign your portfolio to your investment objective. You achieve it by selling assets that have grown too large and buying assets that have shrunk or by redirecting new contributions, depending on circumstances. It helps ensure that your risk level aligns with your goals and risk tolerance but does not guarantee positive outcomes.

Consider your investment portfolio as a seesaw. On the one hand, there are stocks, bonds, and some other alternative investments such as commodities. Ideally, the seesaw remains in equilibrium with the asset classes bearing their respective weight. However, with time, as certain investments rise at a higher rate than others, the seesaw will tip.

Your portfolio might be more weighted on one side, risking more or missing potential returns than originally intended. Rebalancing in a portfolio is the process of restoring balance. It is all about balancing the weight of every investment to keep your portfolio on track with your objectives and risk-taking preferences.

Understanding Asset Classes and Allocation

In simple terms, rebalancing is making asset allocation adjustments and moving funds from overrepresented assets to underrepresented ones based on predefined targets.

Why Should You Rebalance Your Portfolio?

Suppose you created a portfolio consisting of 60% stocks and 40% bonds, with a goal of achieving stable growth with moderate risk. The stock market has been booming for over a year, and bonds remain stagnant. Now, your portfolio has been transformed to 75% stocks and 25% bonds.

Your portfolio is worth more on paper, but it is also a lot more risky than you intended relative to your original strategy. A market slump may now strike even more than you thought, and the safety net you thought you had in bonds is even thinner. This is where portfolio rebalancing is involved.

Maintaining the desired risk levels: By adjusting your allocations, you avoid a single asset class dominating your portfolio, and your risk will be kept at the desired level in line with your objectives.
Supporting long-term portfolio performance: Rebalancing helps you maintain a disciplined approach, selling assets that have become excessively large and buying those that have become excessively small based on allocation targets, to keep your portfolio on track to your financial objectives.
Avoiding excessive exposure to a single asset type: Without rebalancing, growth in one sector will lead to an unbalanced portfolio. It will expose the portfolio to market fluctuations.

Through regular rebalancing, your portfolio will remain in line with your investment objective though market risk remains present. You will have the ability to manage investment risk.

Portfolio Rebalancing Benefits

Here are the key portfolio rebalancing benefits that assist you in keeping your investments in line with your investment objective:

Reduce risk: Your portfolio may become riskier if certain assets increase at a faster rate than others. Rebalancing will bring you back to your initial risk level and will help you manage risk in investments but does not eliminate losses.
Preserve portfolio portfolio: Diversification weakens if a single asset dominates the portfolio. Rebalancing restores balance among assets and serves as a cushion for your portfolio against unexpected market shocks.
Establishes investment discipline: Rebalancing eliminates emotion and strengthens a systematic investing strategy.
Ensures consistent portfolio performance: Rebalancing ensures both short-term profitability and long-term stability. It assists in eliminating excessive fluctuations and makes returns more stable over time without guaranteeing returns.
Keep your strategy on track: You do not change your goals with the market. Rebalancing brings your investments back to your plan and makes your strategy remain relevant.

How to Rebalance Investments: A Step-by-Step Guide

Here is a simple and step-by-step process of ensuring that your investments remain in line with your objectives:

Check your target asset allocation: Start by examining the combination of assets that you initially intended to have. This forms the basis of adjusting your asset allocation. Write down your target percentages in each of your asset classes, like stocks, bonds, and cash.
Evaluate your portfolio distribution: Check how your portfolio actually looks today. Compare your current percentages against your target allocation.
Determine underperforming and overperforming assets: Highlight the assets that have increased more than their target and those that have not. Overweight assets may need trimming, while underweight ones may need topping up.
Choose a rebalancing strategy: Choose how you will get your portfolio back on track:
1. Sell overweight assets and redistribute the proceeds
2. Buy underweight assets using fresh contributions
3. Hybrid approach: combine both selling and new investments
Consider costs, fees, or taxes: Remember that there are costs and expenses associated with every trade. These costs include the following:
1. Commission or transaction charges
2. Capital gains taxes (where applicable)
3. Fund redemption fees
Implement and monitor your adjustments: Implement all the adjustments and monitor your portfolio to ensure it is on track with your target.

Best Practices and Rebalancing Tips You Must Know

Rebalancing a portfolio requires consistency and a disciplined approach. Here are some of the tips you can follow to make the process easier and more effective:

1. Stick to a Schedule

Rebalancing is not a set it and forget it exercise, but neither does it have to be continuous. Select a schedule that fits you:

Time-based: Evaluate your portfolio every quarter or year.
Threshold-based: Rebalance when an asset class has moved more than a predetermined percentage, such as 5-10%.

2. Avoid Emotional Reactions

Markets are volatile, but your portfolio should not react to every news and headline. You should not give in to the temptation of following the trend or panicking when the market is down. Rebalancing is an investment risk management strategy that helps you prevent making decisions in response to fear or excitement.

3. Monitor Portfolio Changes with Digital Tools

Trading apps, dashboards, and online tools make it easier for you to manage and monitor your portfolio. Together, they help you save time and stress by receiving automated alerts that warn you when it is time to rebalance. You can even use a simple spreadsheet with percentages to see the balance of your portfolio at a glance.

4. Remember to Diversify

Portfolio diversification is the essence of rebalancing. Do not allow a single asset group to dominate your portfolio, even when it is doing well. A diversified portfolio is beneficial in risk management, and it also averages returns in the long run.

Common Mistakes to Avoid When Rebalancing a Portfolio

Rebalancing can be a stumbling block even to experienced investors. The following are the most common pitfalls and how to avoid them:

Rebalancing Too Often

Buying and selling in every market movement can impact your returns in the form of fees and taxes. Rebalancing should be a planned strategy that focuses on both short-term risk and long-term growth. This is why you must avoid rebalancing your portfolio too much.

Neglecting Fees or Taxes

Costs can be incurred in every trade, such as brokerage fees, fund exit charges or capital gains taxes. Overlooking them may make a brilliant rebalancing decision and an expensive one. Sometimes, it is preferable to rebalance with new contributions instead of selling current holdings.

Making Decisions Based on Emotions

Fear and excitement are the biggest enemies of rebalancing. Buying when the market is down or following the trend of the hot-performing assets may ruin your long-term plan. Be disciplined and stick to your plan in terms of investment risk management.

Conclusion

Rebalancing your portfolio is an effective way of ensuring that your portfolio stays aligned with your investment objective. It is also a way to ensure that it is exposed to reduced risk. This is why rebalancing and updating your asset allocations help you create a balanced, risk-managed portfolio.

You must remember that the aim is not to pursue every market movement. It is about being disciplined, sticking to your plan and having a smart rebalancing strategy to cushion your growth and maximise the benefits of rebalancing in the long run.

Disclaimer: This content is for educational purposes only and does not constitute investment advice, personal recommendations, or an offer or solicitation to engage in any investment activity. All investments carry risk, including the possible loss of capital. Investors should assess their individual circumstances and seek independent professional advice before making investment decisions.