In order to match the level of returns one expects from their portfolio, it is necessary to rebalance the portfolio on the regular basis. Basically, rebalancing means buying some stocks and selling some bonds or vice versa – a similar maintenance procedure like visiting a dentist regularly. This procedure also helps match the asset portfolio with the level of risk you are ready to take. Rebalancing is a part of the long run of the passive investment strategy. If rebalancing is approached in a disciplined way it can increase long-term returns by preventing the investor from making panicked moves.
Asset allocation
The percentage of different investments in the portfolio is defined as asset allocation. Investors predefine their target asset allocation which can only be reached by regular portfolio rebalancing. Let’s say you hold more stocks. This way the value of your portfolio will be more volatile due to the market swings, therefore you will be taking on more risk. However, stocks usually have higher performance than bonds in the long run. That is why investors tend to expect a bigger part of their returns from stocks.
Typically, rebalancing involves selling stock and reinvesting the money into bonds. It might seem that it is more beneficial to hold 100% of the portfolio in bonds. Yet it is not so from the viewpoint of emotions that every investor has. For example, seeing a retirement account go down due to the decline in the stock market can force an investor to make poor rushed decisions such as selling stocks at a loss. On the other hand, rebalancing portfolios with bonds that are more stable can help keep the portfolio on track to the target allocation and match the desired risk equivalent.
How to rebalance
Although there is no optimal frequency for rebalancing strategy, there is the main principle of how it should be done. Rebalancing mainly represents selling overweight assets.
To take an example, we can imagine that an investor holds 70% stocks and 30% bonds in their portfolio. When a stock market does well, the portfolio value represented by these stocks goes up from 70% to 75%. It seems like a positive change, but in fact, the portfolio becomes riskier. To avoid taking a higher risk, the investor should sell that 5% of the stock and invest that money in buying bonds. That way the portfolio becomes rebalanced.
Without a doubt, selling the stock at the moment when its value grows can be challenging from a psychological point of view. Nevertheless, it is crucial to remember:
- Stocks could go low and bring bigger losses that you were prepared to take;
- Rebalancing in such situations means buying low and selling high which is the desired outcome;
- The process of rebalancing typically involves lower percentages.
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