Last week, I wrote about diversification and the need to have it as part of any investment strategy. Once your investment strategy has been put in place, it has to be managed to ensure that it meets long term expectations and risk exposure. Rebalancing forms a key part of that strategy management.
The different asset classes in your portfolio should not all perform well or badly at the same time. The different timings of their types of performance is useful to the portfolio as a whole because it means that you are diversified.
Equities, for example, might perform better over a given time period than bonds. This would mean that the proportion of the total portfolio that is made up of equities increases from the initial proportion. At the same time, the proportion of bonds in the portfolio would have reduced. This is perfectly natural as the capital markets move up and down in relation to each other. However, the danger is that the portfolio may ‘drift’ so far away from the initial proportions of asset classes that the portfolio is exposed to more risk than we initially designed it to.
Rebalancing is the resetting of the asset classes in you portfolio back to the original weighting.
There are two main methods of rebalancing:
The percentage holding of each asset class is rebalanced at a predetermined date every year.
As the rebalancing takes place at a particular date, you cannot know if it is a good or bad time to be buying equities or bonds. But as we have consistently shown an inability to predict markets, the long term benefits of rebalancing on a consistent basis will provide greater benefits than trying to time the market.
Tolerance range rebalancing
When an asset class drifts by a predetermined percentage, say 3%, the portfolio automatically resets itself to its original weighting. Fund managers use software to track the weighting in portfolios for them. It is too labour intensive to do this manually by checking the weightings on a daily basis.
There are two main benefits to rebalancing:
Sell high, buy low
When it comes to investing, it makes perfect sense to sell high and buy low. So we do we find it so difficult to do? Because we get greedy and hope our investment grows by even more.
Rebalancing at set intervals instills a discipline of selling at a profit and buying underperforming assets at a low price (if it is done under the risk tolerance method, you won’t even be aware of when the rebalancing takes place). You will not always sell at the optimal price but over the term of the investment, you will do pretty well.
Deciding on the level of risk you were exposed to was a big factor when deciding your investment strategy. So why would you unintentionally move away from that strategy?
As the asset classes drift, especially equities in a bull market, your overall risk exposure increases. For example, you may go from having a 40% equity holding to a 60% equity holding. Are you willing to accept the risk exposure of that risk exposure?
Do you have a rebalancing mechanism in place for your investment portfolio or do you just let it drift? Do you know what level of risk you started off with and what it is now?
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