Once we have decided what we want to invest in and our asset allocation – that is, the composition of our investments – the next step is to stay on course. Rebalancing the investment portfolio is a key step to ensure that our plan can withstand market turbulence.
What is portfolio rebalancing?
Portfolio rebalancing, also known as reallocation and rebalancing, involves returning the asset allocation of the portfolio to the levels previously defined in our investment plan.
This composition changes due to market fluctuations. Imagine you’ve decided to invest in stocks and bonds in a 60/40 ratio. If stocks rise for a while, their value in your portfolio will grow. Consequently, stocks may no longer represent 60% of the portfolio, and their increased value may now account for 80% of your assets. Rebalancing the portfolio means restoring the initial balance. In this case, it involves selling stocks – and buying bonds – until the equity component again represents 60% of your investment portfolio.
Why is it necessary to rebalance the portfolio?
You might think that if your stocks are performing well, there’s no need to sell them. Obviously, you shouldn’t sell every time your assets change in value; in fact, this would be a poor strategy. But consider that, just as they go up, your stocks can also go down again. If you now have more stocks than before, you expose yourself to larger losses.
Furthermore, the different portfolio composition implies not only changes in returns but also in risk. If you are comfortable with a 60/40 allocation between equities and fixed income, it’s because you want to offset the volatility of stocks with a large percentage of bonds. If the allocation changes, the overall risk of your portfolio also changes.
Anyway, keep in mind that if you sell part of your stocks when they are expensive and buy bonds when they are cheaper, you are doing exactly what every investor dreams of achieving. In fact, this same principle is behind another key strategy we’ve discussed on the blog, dollar-cost averaging.
When should you rebalance the portfolio?
The idea of restoring balance to our investments should not lead us astray. Just as it doesn’t make much sense to try to predict the market, it is not efficient to constantly review the portfolio’s composition. Among other things, because adjustments are typically associated with costs.
Finance journalist Jason Zweig recommends the following: “In an investment account with funds or plans, you can rebalance without even generating a tax bill. Do it twice a year, every year, on two easy-to-remember days approximately six months apart, such as your birthday and a religious feast day, or during your bi-annual dentist appointment. The more your investments fluctuate, the more benefit you’ll gain from rebalancing.”
In summary, periodically rebalancing the investment portfolio is essential to maintain the desired balance between risk and return in our investments. It’s also a good antidote to making investment decisions driven by trends, enthusiasm, or despair.
