The idiom “don’t put all your eggs in one basket” is commonly used when it comes to investing – or more specifically, to managing investment risk. If something goes astray with the one basket, you may lose all your eggs. To prevent this from happening, you need to put your eggs in multiple baskets.
This is the concept of diversification. An extension on diversification being used to manage risk is portfolio rebalancing. If, over time, eggs move from one basket to another, then we use rebalancing to even them back out, so you are not over-exposed in one or two baskets.
What is portfolio rebalancing?
Portfolio rebalancing is the process of realigning the weightings of a portfolio of assets. Rebalancing involves periodically buying or selling assets in a portfolio to maintain an original or desired level of asset allocation or risk.
For example, say the original target asset allocation for a growth-oriented investor is 80% stocks and 20% bonds. If the stocks perform well during a given period, the stock weighting of the portfolio might increase to 90%. The investor may then decide to sell some stocks and buy bonds to get the portfolio back to the original target allocation of 80/20.
‘Rebalancing’, as a term, has connotations of an even distribution of assets – however, a 50/50 stock and bond split is not required. Instead, rebalancing a portfolio involves the reallocation of assets to a defined makeup, and applies whether the target allocation is 50/50, 80/20 or 40/60. Investors may also adjust the overall risk within their portfolios to meet changing financial needs.
The importance and benefits of rebalancing your portfolio
The primary objective of portfolio rebalancing is to safeguard the investor from being overly exposed to undesirable risks. Rebalancing is undertaken to ensure the amount of risk is consistent with the investor’s desired level.
Consider a retiree who has a target asset allocation of 30% stocks/70% bonds. In the absence of portfolio rebalancing during a period in which stocks performed well, the composition of the portfolio might change to 45% stocks/55% bonds. This leaves the investor more exposed to stocks, and risk more generally, than intended.
Stock performance can vary much more dramatically than bonds, and so the percentage of assets represented by stocks can change significantly as market conditions vary. Rebalancing gives investors the opportunity to sell high and buy low, taking gains from high-performing investments and reinvesting them in areas that have not yet experienced such growth for example.
When to rebalance your portfolio
While there is no one correct schedule for rebalancing a portfolio, a common approach is to examine allocations at least once a year. Calendar rebalancing is the most rudimentary rebalancing approach. This strategy simply involves analysing the investment holdings within the portfolio at predetermined time intervals, and adjusting to the original allocation at a set frequency.
Quarterly, semi-annual, or annual assessments are typically preferred, because weekly or monthly rebalancing would be overly expensive, while a period greater than a year would likely allow for too much intermediate portfolio drift.
The ideal frequency of rebalancing must be determined by the investor based on time constraints, transaction costs and allowable drift. A major advantage of calendar rebalancing over more responsive methods is that it is significantly less time-consuming and costly for the investor since it involves fewer trades, and can be made at pre-determined dates.
A more responsive approach to rebalancing focuses on the allowable percentage composition of an asset in a portfolio – this is known as a constant-mix strategy with bands or corridors.
Every asset class, or individual security, is given a target weight and a corresponding tolerance range. For example, an allocation strategy might include the requirement to hold 30% in emerging market equities, 30% in domestic blue chips and 40% in government bonds, with a corridor of +/- 5% for each asset class. Basically, emerging market and domestic blue chip holdings can both fluctuate between 25% and 35%, while 35% to 45% of the portfolio must be allocated to government bonds. When the weight of any one holding moves outside of the allowable band, the entire portfolio is rebalanced to reflect the initial target composition.
Will there be tax implications?
Because rebalancing can involve selling assets, it often results in a tax burden. The process of rebalancing means you may incur capital gains tax on any profits made on the sale of investments. But if you don’t rebalance, you may find yourself overexposed to a market fall in one particular asset class.
Investors should always consider any taxation-related matters with their accountant or tax adviser.
What is automatic portfolio rebalancing?
Some brokerage platforms enable you to set specific percentages for each asset in your target portfolio. This can allow additional investments/contributions to be directed into positions that are currently ‘underweight’, reducing the exposure to ‘overweight’ assets as the size of the portfolio increases. This allows you to rebalance as accurately as possible without selling shares. This is most relevant for investors who make regular contributions to their investment portfolio.
Portfolio rebalancing aims to safeguard investors from becoming overly exposed to undesirable risks. It can incur brokerage costs or fees and tax implications, but allows investors to maintain a desired asset allocation, with the aim of not leaving them overexposed to a market fall in one particular asset class.
Formerly Managing Editor at Livewire Markets. Passionate about investments, markets, and economics.Read more from Patrick.