What is rebalancing? Should I rebalance my portfolio? How often should I rebalance my portfolio? How do I rebalance my portfolio? What affects does rebalancing have on a portfolio?
Prudent investment principles such as asset allocation and global diversification are valuable tools for managing risk and volatility in a portfolio. But maintaining the proper structure of your portfolio is just as important. Once you have established a portfolio allocation that suits your unique financial situation and risk tolerance, rebalancing helps you stay on track for achieving your long-term financial goals.
What’s Rebalancing’s Effect on a Portfolio?
We’ve all heard the investing adage that we should “buy low, sell high.” This is exactly what rebalancing attempts to accomplish…taking money from assets that have performed well and reinvesting in assets that haven’t. Rebalancing helps keep your portfolio allocated to your desired mix of stocks and bonds. Without rebalancing, your portfolio can drift from one level of risk to another as the markets change. This drift can add extra risk to your plan that you never intended or expected.
Rebalancing does not guarantee greater returns over every period, but it can help reduce portfolio risk and should deliver better risk-adjusted returns over time. In bull markets, rebalancing can test an investors’ resolve…because when markets are trending upward, rebalancing will continually sell the strongest performing asset and invest in the weaker performing assets. For example, during
prolonged periods when stock returns are higher than bond returns, not rebalancing will produce higher returns, but at the cost of increasing portfolio risk. This is because higher returning asset classes, with higher risk, will increase in a portfolio over time. As you can see from this chart, the annually rebalanced portfolio was less volatile over the last 20 years. It may not have soared as much during bull markets, but it didn’t decline as much during bear markets. And overall, it offered slightly better performance with less risk than the drifting, un-rebalanced portfolio.