Rebalancing

Rebalancing is a powerful strategy

Rebalancing is the process of buying and selling to bring your portfolio back to your target allocation. Your portfolio's components will change overtime due to market forces, some will do better than others, those that done well will take up a higher percentage of the portfolio. You need to readjust to bring the portfolio back to the original balance. Rebalancing is about risk management to ensure that your portfolio is not dependent on a single asset class to succeed or fail. If your risk profile has change, then you need to revise your asset allocation according to risk appetite.

Rebalancing helps you to reap the full rewards from diversification, by scaling down on your winner, you will free up your resources and reposition them to your laggard. Rebalancing helps to remove the psychological factor of investor in the market cycle.

How to Do That?

Step 1 Set your target portfolio mix

Firstly, you need to determine all you asset classes and fix on the investment styles which will lead you to your investment goal. For instance, Jason has $100,000 to invest. He decides to invest 50% ($50,000) to stocks, 20% ($20,000) to bond, 10% ($10,000) to gold and remaining 20% ($20,000) to cash. This is the opening balance and he will like to remain in this portfolio mix.                          

Step 2 What is the difference?

Compare your target component to your present component. Then determine where your investments are not performing. Do you have a larger stake in a riskier company stock? Then consider your sector exposure, this is to ensure you will not have over exposure in particular industry. Then look at your investment to understand which one has performed the best. Continuing from previous example of Jason, at the end of the year, his stocks has grown to $75,000 , his bond has drop to $15,000 , gold has drop to $5,000 and cash remains the same. Total portfolio value is (75,000 + 15,000 + 5,000 + 20,000 = 115,000). The percent of stocks to his total portfolio values will be approximately 65%, bond to portfolio value will be 13%, gold will be 4% and cash will be 17%.

Step 3 Readjust

Then it is time to bring components of portfolio which has grown and direct the money to the investment which have not.

In this situation, Jason needs to sell his stocks and bring it back to 50%, so he need to sell to a level of approximate $57,500. This will bring some of his cash position to 20% which is $23,000 and the rest will be used to purchase additional bond and gold.

When do you need to rebalance?

You should conduct a thorough check on your portfolio once a year but only rebalance when it is not within your target. For example, you might rebalance when your allocation of stocks has exceeded 60% before you need to make changes. Hands off investors can set a higher limit by another 10% relative to their targets.

Costs of Rebalancing

During rebalancing, you need to cater for transaction costs to execute and process the trades, there will be commission, stock exchange fees, and taxes. For mutual funds, costs will include purchase or redemption fees. This will incur time on your side and if you engage a professional investment manager, you will incur administrative and management fees. If there is an increase in transactions, over the long run, it will affect your returns.

Strategies of Rebalancing

The portfolio can be rebalanced on a time-only strategy, it can be rebalanced daily, monthly or yearly basis. The second strategy will be on the limit of portfolio, you can predetermine rebalancing threshold such as 1%, 5% or 10%. The third strategy is to combine time and threshold. Rebalancing with dividends, interest payments, realized capital gains or new contributions can help investors exercise risk control and reduce the cost of rebalancing.

Conclusion

Rebalancing helps you to maintain your desired original asset allocation, allow you to fine tune according to your risk profile and remove emotions during investing.