Rebalancing your portfolio is one of the most important aspects of investing. In fact, it has been called “the only free lunch” in the financial industry due to the benefits it provides for investors. Yet, despite the benefits, many investors don’t take advantage of this investment tenant – either due to simply forgetting or not understanding the importance. These advantages are even greater now than they were during previous market cycles.
Many investors use rebalancing as an investment strategy to ensure that their portfolios remain aligned with their long-term goals. The idea is to restore your asset allocation model to its original target weightings. This is achieved either by buying or selling investments so that each has a proportionate share of your portfolio's assets.
But how often should you be doing this? And, what factors should go into deciding whether rebalancing is necessary?
Explore these topics with us:
Rotate Your Portfolio’s Tires
If you own a car, you may be aware of the necessity of rotating your tires about as often as you change the oil. This basic, routine-maintenance task avoids uneven wear on the treads (which can eventually become a safety factor).
In some ways, rebalancing your investment portfolio is similar: just as your tires should be adjusted for optimal driving results, rebalancing adjusts your assets, which can fare better or worse with changing market conditions. Wise drivers want proper traction from their tires, just as wise investors want the best performance from their investments.
Therefore, a portfolio should be rebalanced regularly to avoid common behavioral pitfalls. Closet indexing investors often make one such error. They put all their money into a single fund because they do not want to spend time researching which funds are best suited for them.
Although they may own more than one fund, they have no idea how their investments are performing relative to each other (or if any of them are lagging behind their benchmark index over time). In other words, it could be months or even years before they realize that some of their funds have performed poorly.
Rebalancing can also help you avoid chasing returns. This mistake is made when an investor buys shares in companies whose stocks have recently risen sharply in price. People mistakenly think that good investments must come from high-performing stocks. Historical evidence suggests otherwise, but it can be difficult getting them to review it.
Fundamentally, rebalancing is the process of periodically buying or selling assets in your investment portfolio to maintain its desired asset allocation. For example, imagine your target allocation is 70% stocks and 30% bonds. You invest $100,000 across three different funds: a U.S. stock fund (a total stock market fund), an international stock fund, and an intermediate-term bond fund.
After one year, stocks have done well, representing 73% of your portfolio. Meanwhile, bonds have lagged, so now they represent 27%. It would be beneficial for your overall financial health to bring these two numbers closer together again. So, you sell some stocks and buy some bonds until they reach their original levels.
In this example’s case, you sell $27,000 worth of stocks ($73% * $100k) and buy $23,000 worth of bonds ($30%). This puts you back where you started, right at 70/30.
Additionally, it is important to understand the taxes involved when trading in your account and the importance of holding an investment for over 365 days. If you are unsure if you are behaving in a tax-efficient manner, it may be wise to consult with your financial planner or tax adviser.
Whatever approach you choose for investing, be sure that it fits with your risk tolerance, time horizon, and financial goals.
When it is done professionally, rebalancing takes all three of these factors into consideration. There is no rule stating that you cannot attempt this yourself, but it can get more complicated than the simplified examples above may sound. That is why we believe that a fiduciary financial planner is an invaluable ally—optimal for worry-free rebalancing and long-term goal achievement.
Rebalancing should also include diversification. The reason why is simple: if you are keeping most of your money in one type of investment, such as stocks or bonds, then a downturn in that area could hurt your portfolio. Diversification spreads your money across different types of assets so that you are not overly exposed to any one kind.
In a perfect world, this would eliminate all elements of risk completely. The reality is that—while diversifying normally reduces risk—it cannot eliminate all risk, whatsoever. So, diversification is about mitigation (or reducing it to the lowest amount possible).
Again, if you diversify and invest some of your money in several different stocks and those stocks lose some (or all of) their value, that loss would still be less than if all of your money was invested in just one company or industry.
When rebalancing your portfolio, remember to seek a variety of asset classes, if possible. In other words, seek different types of investments that are grouped together because they share certain characteristics or qualities.
Examples might include stocks, bonds, and mutual funds. Meanwhile, you may want to consider alternative investments, as well. These range from commodities, like soybeans or aluminum, to commercial real estate (CRE). Diversifying into alternative assets like CRE may provide a hedge against inflation, since interest rates almost never affect its value.
Asset classes can be grouped together because they have similar risk profiles (for example, how much risk each class carries). They can be classified according to their returns over time, as well. For instance, large-cap stocks tend to be less volatile than small companies or emerging markets (though you should not completely ignore the other two types).
There are many benefits to rebalancing your portfolio. It can help you manage risk, buy low and sell high, and ensure that your assets are well diversified. However, it is important to remember that rebalancing doesn't eliminate risk—it just reduces it.
For an investment strategy that will protect your money from market fluctuations over time (including those caused by inflation), consider a balanced fund or asset allocation plan. While we respect the D-I-Y spirit, we remain convinced that a fiduciary wealth manager is your best choice to rebalance portfolio assets.
This is only one of many financial services TrustCore Financial Services, LLC offers. Contact us to schedule your complimentary appointment today. You might find out why some of our clients may say we remain the best financial advisor Brentwood, TN, has available.
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