An investor’s portfolio may contain different types of assets. For example, stocks, bonds, and gold. Their price rises or falls in different ways and the structure of the portfolio, its profitability, and the level of risk for the investor change along with it. To avoid this, the portfolio should be rebalanced to restore its original structure. Let’s figure out in more detail what rebalancing does and how to do it.
What Is Portfolio Rebalancing?
Your portfolio should always consist of several asset classes. For example, certain proportions of shares, bonds, ETFs, or fixed-term deposits. You need to think carefully about this composition. Ideally, it should correspond to your personal risk tolerance. However, because different investment markets also develop differently, the portfolio has to be rebalanced from time to time.
Rebalancing means the restoration of the original composition in the portfolio by buying and selling securities. This brings the relationship between return opportunities and risks back into balance – hence the name “rebalancing”. It is intended to ensure that the risk taken does not increase uncontrollably in the long term and most online brokers, such as Brokstock and Interactive Brokers, actually offer functionality to help with this.
The share of equities in particular fluctuates comparatively strongly. If the stock markets are on the rise, the prices of the equity positions in the portfolio increase. Depending on how strong the price increase is and how long it lasts, a balanced portfolio can become a risky one. Conversely, when share prices fall, the other asset classes gain weight.
What Benefits Come From Rebalancing?
So, during rebalancing, the investor restores the original proportions of assets either by contributing more money to buy up the declining assets or by selling the assets that went up in price and using the proceeds to make up the missing shares. But what is the actual benefit of this?
Tax Benefits
In most European countries, the US and Canada, capital gains are tax-free to a certain amount. This means that if you sell your assets under that amount you will not need to pay taxes on the profit you might have made. Rebalancing ensures that in 10 years you will not need to sell a big portion of your portfolio and potentially lose a lot of profits to taxes.
Risk Management
Market fluctuations often lead to an increase in the proportion of risky investments. The “new” portfolio then no longer corresponds to the original risk tolerance. With rebalancing, the portfolio is “reset”, so to speak, and brought back to its original composition.
Reduction in Volatility
In the stock market, volatility refers to the deviation of an asset’s price or return from its average value over a certain period. The higher the volatility, the higher the risk. The prices of some assets are very volatile and can rise or fall significantly in one day, which affects the value of an investor’s portfolio.
Rebalancing helps to get rid of the volatile assets as soon as possible, which is good for your portfolio in a long term. Volatility is often called the most common companion of risk – but there are risks that volatility does not capture. Standard deviation is the typical method for measuring volatility. This is true for individual securities and for entire portfolios.
How Often to Rebalance Portfolio?
So, for cost reasons and to keep tax payments low, annual rebalancing is a good idea. It increases the annual return of a well-diversified portfolio in the long term, while the risk hardly changes or decreases minimally.
There are two basic approaches to determining when it is time to rebalance a portfolio:
- By calendar. The investor chooses how often they will check to see if the asset allocation in the portfolio has changed. For example, on the last business day of each month or once a year in mid-July. If required, the investor rebalances the portfolio on that day.
- By deviation. A more complicated way is to rebalance a portfolio if the asset shares have deviated from the right ones by a certain amount. This requires regular monitoring – up to and including daily monitoring.
An example of the deviation approach is the 5/25 rule. It calls for rebalancing if the share of an asset in the portfolio has deviated by five percentage points or 25% of the desired share – whichever comes first. For example, gold’s share of the portfolio is 10%. Rebalancing will be required when the share of gold drops below 7.5% or becomes higher than 12.5%. What deviations are acceptable, the investor decides for themselves.
Types of Portfolio Rebalancing
If your analysis of the portfolio indicates that rebalancing is needed, here are some ways you can bring your portfolio to its original composition:
- Sell assets with a higher allocation and use that capital to invest in assets with a lower allocation.
- Direct new cash flows (when buying and selling) into investments with lower allocations to bring them back in line with your target. New cash flow should generally be directed back to the original allocation. This is because there are no additional costs or taxes due.
- Unexpected life events, such as the birth of a child, marriage, or the death of a family member can change your goals and time horizon. When these situations occur, you may want to rebalance, even if it’s not scheduled. Make adjustments and continue to use the monitoring method that works best for you.
To increase the efficiency of investment management, you can combine all of these methods of rebalancing your portfolio.
The Bottom Line
Despite the fact that there is an ongoing debate on portfolio rebalancing, most experts agree that it is still necessary. Otherwise, one day an investor may find that assets of one type take up almost all of their portfolio, which entails huge risks. But frequent rebalancing is associated with high fees and taxes. Therefore, in order to reduce investment risks and incur minimal costs, it is recommended to carry out this procedure once a year or as needed, if the share of assets in the portfolio has changed significantly.
