Your Investments: When to rebalance your portfolio

Rebalancing is important for 2 reasons: It keeps portfolio in tune with long-term goals, it keeps asset allocation in line with risk level.

By AARON KATSMAN
May 11, 2011 22:26
3 minute read.
Katsman

Katsman 58. (photo credit: courtesy)

 
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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.

ASSET ALLOCATION

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.

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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.

Assuming that 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 $40,000 invested.

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 30% bonds.



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 shrinks.

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 into.

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 allocation.

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 account.

aaron@lighthousecapital.co.il

Aaron Katsman is a licensed financial adviser in Israel and the United States who helps people with US investment accounts.

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