(photo credit: courtesy)
Perhaps the most overlooked aspect in long-term investing is the need to
rebalance your portfolio. Rebalancing is important for two main reasons: first
of all, it keeps your portfolio in tune with your long-term goals; secondly, it
keeps your asset allocation in line with your risk level.
As I’ve mentioned in previous columns, creating your asset
allocation, or the mix of stocks, bonds and cash in your portfolio, is the
single most important task you can take as an investor.
Many studies have
indicated that the proportion in which you hold stocks, bonds and cash has a
greater effect on your portfolio’s returns and its volatility than the
individual investments you choose.
That’s why after assessing your
investment goals, it’s of utmost importance to create an allocation that can
help you achieve them.WHY REBALANCE
Let’s say you decide that an
allocation of 60 percent stocks and 40% bonds is right for your $100,000
portfolio. Let’s also assume that over the course of the next few years, the
stock market moves up strongly, and bonds barely move up.
all gains and dividends where reinvested and you didn’t deposit or withdraw any
money, the stock portion of your portfolio would be worth a lot more than the
initial $60,000, while your bond holdings would be worth a little more than the
The good news in such a scenario is that your portfolio
bigger. Unfortunately, it’s also riskier. Why? Because your portfolio may have
gone from a 60% stock and 40% bond allocation to an allocation of 70% stocks and
In times when stock returns are much higher, many investors
can find themselves with portfolios much more heavily tilted toward stocks then
when they started out. Conversely, if bond returns outpace stocks returns by
enough of a margin, your portfolio could become more bond-heavy, or
conservative. The point is that by just sitting and doing nothing, your
portfolio can change into something you don’t want it to be.
The way to
avoid a portfolio that changes into something that is either to conservative or
aggressive for you is by rebalancing your portfolio, or fine-tuning it to bring
it back to your original allocation or one that meets your updated
needs.BUY LOW, SELL HIGH
Rebalancing also forces you to do something
investors all say they want to do but rarely have the discipline to pull off:
sell high and buy low. If stocks have a great year and bonds tank, then the
stock portion of your portfolio jumps in value, while the bond part
To bring your portfolio back in line, you’ve got to sell some
high-flying stocks and put the proceeds into bonds.
By doing this you
have accomplished the principle of buying low and selling high. By constantly
updating your portfolio, you won’t fall into the trap most investors fall
Investors often either become consumed by fear when markets fall
and instinctively sell, or when the market is high they become consumed by greed
and continue to buy. By definition, rebalancing means you sell high and buy
low.HOW OFTEN SHOULD YOU REBALANCE?
While there is no hard and fast rule
of when to rebalance, the conventional wisdom recommends doing it on an annual
basis. If your original allocation called for 70% of your portfolio in stocks
and you have 71.5% instead, don’t rush to sell the additional 1.5%. It pays to
rebalance if there is an imbalance of 5% from your intended
In addition, if your goals have changed, you may also need to
rebalance.SELLING ISN’T THE ONLY WAY TO REBALANCE
You don’t need to sell
to rebalance your portfolio. You also can do it by adding money to your account.
Then, for example, if you want to increase the amount of the fixed-income
portion, you can buy more bonds. This style of rebalancing provides you with the
asset allocation you want, while also increasing the value of your
Aaron Katsman is a licensed
financial adviser in Israel and the United States who helps people with US