Rebalancing your portfolio can be an easy task to overlook, especially for those adopting a long-term view and buy-and-hold strategy, yet without doing so can lead to volatility and losses have a negative impact on your returns. Let’s look at why rebalancing should always be a feature in your investment planning.
What Is Rebalancing?
When constructing a portfolio, you will likely have decided to pick a portfolio of stocks/equities, bonds and some other asset classes, divided up into different weightings to diversify your strategy; a common weighting is 60% stocks, 40% bonds, for example. As these investments generate profits and losses, the initial weightings will stray from their allocation and your portfolio will become unbalanced from the original settings.
Simply put, your portfolio may end up being heavier/less weighted in one asset compared to the original allocation; for example, stocks become 70% and bonds 30%. Since weightings are normally decided alongside risk appetite, when it is unbalanced it can lead to greater losses in market downturns.
Now, I get it — when one of your assets is performing spectacularly and rebalancing means selling its profits, you might be hesitant to do so. However, rebalancing doesn’t have to be an overly frequent task; as often as once a year, for most long-term investors, is more than adequate. The discipline to rebalance at a regular interval is important, as is what rebalances can help shield against.
Why Rebalance?
As mentioned, it’s great to see winners making gains and opting to let them ride without rebalancing, for apparent greater returns. This has proved well over the last 10-year period, but going over 20 years it incurred significant downturns over the 2000 period if no rebalancing was taken.
Rebalancing — instead of being used to yield greater returns — should be seen as a method to reduce portfolio volatility and improve risk-adjusted returns over the long term. Looking at data from 1994, Morningstar discovered that the returns from a buy-and-hold approach versus annual rebalancing didn’t pull ahead.
Yes, the last 10-15 years have been kind to stocks, but the long-term view evidences how quickly market downturns can negatively affect a portfolio that isn’t rebalanced to the investor’s risk profile.
How Often Should I Rebalance?
There is no perfect solution on when to rebalance, more so a focus on the discipline to consistently do it as part of your strategy. That said, you may wish to explore a frequency that fits your personal style for your portfolio, or start as simply as once a year.
For example, see the data for portfolios that are left with no rebalancing whatsoever and how much this affects the allocations:
5 Years Since Rebalancing
3 Years Since Rebalancing
One Year Since Rebalancing
As expected, more years may impose greater deviance from original allocations, which — as we have seen — may have negative impacts on your returns. (See the original article for a full contextual breakdown of these figures).
Knowing this, suggesting at least a yearly rebalancing allows portfolios not to stray too far from their allocations, at least in the sense that they can be easily managed at once a year whilst without tinkering too much with your buy-and-hold strategy — this keeps trading costs minimised whilst keeping your portfolio on track.
Rebalancing too frequently can also eat into trading costs, which is something buy-and-hold strategists aim to reduce. However, you may opt to rebalance quarterly or half-yearly, which may align with when you conduct your portfolio reviews, and still benefit.
Another noteworthy method is something called “threshold rebalancing”, which may be a method you wish to implement:
This method may, perhaps, open up more rebalancing, but could be a way in which to keep a tighter control on your allocations throughout the year, if you so wish. At the time when you come to rebalance, you could assess whether or not you need to do so, if the weightings haven’t passed the 5% threshold, for example.
Ultimately, as Vanguard has pointed out, the specific timing of rebalancing doesn’t matter nearly as much as just embracing it in the first place. Any sensible rebalancing strategy is likely to lead to better risk-adjusted returns than a buy-and-hold approach, which can lead to a risk profile that’s no longer in line with your comfort zone. (Morningstar)
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