Rebalancing a portfolio is a vital investment strategy. When you create your portfolio, your risk profile and financial goals naturally determine the asset allocation within your portfolio. Over time, the performance gap of each asset class can create an imbalance.
In this article, we have explored what rebalancing is, why it’s important and the different types available so you can make more informed decisions.
What does rebalancing a portfolio involve?
Rebalancing involves adjusting an asset portfolio’s weightings to return back to its desired proportion. A simple example would be If you established a portfolio, and set your target allocation to be a 50/50 split of equities and bonds.
If stocks do well over time, the portfolio’s equity weighting may automatically rise to 70%, leading to an imbalance. The portfolio might then be rebalanced by selling stocks and buying bonds to return to the original 50/50 target allocation.
Why is rebalancing a portfolio important?
The first benefit of rebalancing a portfolio is that it keeps your portfolio’s allocation at the degree of risk that you, as an investor, are ready to accept. Therefore, it serves primarily as a risk management method for a portfolio of investments.
Rebalancing a portfolio can also potentially boost your portfolio’s total return by selling what has been appreciated and buying what has decreased, but of course, this depends on market trends.
Rebalancing a portfolio can be done by experienced individual investors or handled by portfolio managers, such as the advisors at Brite. This will guarantee that the rebalancing process will be a methodical, emotionless investment strategy that can keep risk exposure at levels suitable for each client.
How does rebalancing a portfolio work?
Rebalancing a portfolio can be achieved by transferring assets or selling investments from an overweight asset class, and using the proceeds to purchase investments from an underweight class. However, it can also be accomplished by adding fresh funds to an underweight class or taking money from an overweight class.
Investors sometimes wrongly understand rebalancing a portfolio to mean adjusting for an even distribution of assets. A stock and bond split of 50/50 is not necessary, though. Target asset allocation for a portfolio could be 10% cash, 40% stocks, 50% bonds, or 70% stocks and 30% bonds. It’s important to remember that the distribution is determined by the demands and ambitions of the investor; there is no perfect split that is always the right balance.
When is rebalancing a portfolio necessary?
Investors are advised to review allocations at least once a year. However, there is no set time frame for rebalancing a portfolio. Investors are not required to rebalance, although it is typically not a good idea.
Regarding the frequency of rebalancing, there are several options. One can regularly rebalance or whenever a weighting crosses a predetermined line deemed “unacceptable.”
The first method has the advantages of cost and simplicity. Still, the second method, of waiting for your portfolio balance to cross this red line, is more sensitive to market movements.
Types of portfolio rebalancing
There are several types of portfolio rebalancing strategies available. Regardless of your level of wealth, a constant-mix strategy seeks to maintain the optimal mix of assets, as mentioned above. It is a more responsive strategy that emphasises the permissible percentage composition of each asset in a portfolio.
A goal weight and corresponding tolerance range are assigned to each asset class or individual security. The entire portfolio is rebalanced to match the initial target composition when the weight of any one holding moves outside of the permissible zone.
Smart beta rebalancing is a regular rebalancing process that indexes go through to adapt to changes in stock price and market capitalisation. To eliminate the market inefficiencies that enter into index investing, smart beta techniques use a rules-based methodology.
In addition to using additional criteria, smart beta rebalancing adds a layer of systematic analysis to the investment that standard index investing does not. Emotions are removed from the process during smart beta rebalancing, which is one of its main advantages.
Rebalancing a portfolio and pension planning
It is prudent to take higher risks when the investment horizon is still far away and minimise the risk as retirement draws near regarding pension planning. Rebalancing can be performed to gradually change your portfolio’s weighting over time.
This lessens the likelihood of a sudden reduction in value when the amount saved for your retirement can be retrieved to produce an annuity.
Rebalancing a portfolio at Brite
At Brite, we distinguish between risk profiles and regularly assess the suitability of a portfolio’s actual risk level for each client. As soon as an investment portfolio’s effective risk exceeds the client-set target threshold, we aim to rebalance it as soon as we can.