If you got to this point, you probably already achieved a great portfolio that fits your goals and expectations. However, you are not done there. True investing is a long-term game that requires some level of attention and care.
Many inexperienced investors may get really excited when they start investing. They probably watch their portfolios go up and down daily, freaking out at any slight downturn or correction and selling too early ultimately recording huge losses. The thing is, investing is a really exciting endeavor; but in order to control it, you have to control your emotions first.
Developing a solid portfolio rebalancing strategy will help you avoid those beginner mistakes and keep a consistent, winning portfolio over time.
We introduced portfolio rebalancing into our investment framework because it is so important to help you achieve your goals in the mid/long-term.
What is rebalancing?
In investing, rebalancing is simply the process of rea-adjusting the percentage weights of the assets in your portfolio.
As you know, investing is an ever-changing game, and your assets will increase or decrease in value at different paces, getting your allocation percentages out of whack.
How rebalancing works
In order to rebalance your portfolio, or to get it back to your desired allocation, you will have to buy a certain amount of shares of some assets and sell a certain amount of other assets, which will realign the weights you originally wanted.
Let’s see a quick example to explain this:
Imagine you invested $2,000 five years ago. You allocated 50% (or $1,000) to stocks and 50% (or $1,000) to bonds and you didn’t look at it until today.
Today, you find out that your initial $1,000 allocated to stocks has grown to $1,800 over five years; however, your other $1,000 allocated to bonds has only grown to $1,200. So, your ending portfolio value is $3,000 ($1,800 + $1,200). If we recalculate what our current allocation is, we see that it isn’t 50/50 anymore, now it is 60% to stocks ($1,800 / $3,000) and 40% to bonds ($1,200 / $3,000).
In order for you to rebalance your portfolio and get it back to its original 50/50 allocation, you will have to sell some stocks and buy some bonds. We follow this simple process to see how much to buy and sell:
Current value $1,800 / $3,000 portfolio value = 60% current allocation
Desired allocation 50% – 60% current allocation = -10% to rebalance (sell)
-10% x $3,000 portfolio value = -$300 to rebalance (sell)
Rebalanced value = $1,500 worth of stocks
Current value $1,200 / $3,000 portfolio value = 40% current allocation
Desired allocation 50% – 40% current allocation = 10% to rebalance (buy)
10% x $3,000 portfolio value = $300 to rebalance (buy)
Rebalanced value = $1,500 worth of bonds
Importance of rebalancing
From looking at the previous example you may be thinking: well, if stocks did so much better than bonds, why not keep it like that?
Here is why not:
Rebalancing your portfolio periodically has been proven to be much more effective in the long-run. It helps you avoid unnecessary risks and it keeps you on track with your set objectives.
Avoid undesired exposure to risk
As we have been discussing, asset allocation is about balancing risk and reward. So the inevitable changes in your asset allocation over time (like the one we saw in the above example) can cause your portfolio to be skewed towards an allocation that takes too much risk or too little risk based on your objectives.
From the above example, we can determine that the 5-year period was a bull market (the value of the assets increased significantly). So, in this case, it is great to allocate more money to stocks (they tend to do very well in good markets). However, not rebalancing your portfolio would set you up to suffer much bigger losses in case a downturn occurred.
Stay in your “risk comfort zone”
Rebalancing your portfolio will get you from taking too much (or too little) risk right back to that sweet spot where you are taking a comfortable amount of risk.
Keep a consistent portfolio strategy
Rebalancing is the tool that helps you stay on track with the strategy that you thoroughly prepared, the one that will ensure you achieve your goals and stay within your constraints.
If you have followed our clear steps to create your portfolio strategy from scratch, you will have arrived at a certain allocation which you believe will help you achieve your goals, this is your target (or desired) allocation.
Periodic rebalancing is essential to keep your portfolio at or as near as possible of your target allocation, which is in line with your plan.
Develop your investment discipline
Throughout this course, we have been trying to convey that true, successful investing requires a certain level of discipline. We have slowly built up a portfolio strategy that will help you succeed; however, if this strategy isn’t consistently followed, it will be useless.
Many investors, inexperienced as well as experienced, may start with a solid strategy and with their best intentions to follow it, but they end up falling prey to the media and the red numbers in the news. That’s when they start acting emotionally and making mistakes that will cost them.
That’s why it is so important to develop a discipline in following your strategy. You must incorporate a rebalancing plan in your overall portfolio strategy that will help you stay on track and keep your mind straight.
Even though there is no standard timeframe for investors to rebalance their portfolio, it is recommended that it should be done once a year at the very least.
There are multiple rebalancing strategies out there depending on your level of involvement with your investments (active or passive).
Active investors will make adjustments to their portfolios very often, sometimes even daily, and will try to benefit from market inefficiencies by timing the market, which is proven to work against them over time.
Passive investors typically don’t want to look at their investments often, they may take a look every so often to see that everything is ok and to rebalance their portfolios.
We believe that the ideal mentality of an investor should be somewhere in between these two opposites. Some level of involvement with your investments is important to achieve your goals, but too much involvement is likely you to lead to failure.
So create a rebalancing strategy with a set timeframe. It could be weekly, monthly, quarterly, semi-annually. Whatever timeframe you choose, stick to it. Be consistent and deviate as little as possible from it.
What portfolio rebalancing looks like
We will continue with Jim’s example from previous sections.
He is just starting in the world of investments but he understands the level of discipline it takes to be successful and set a rebalancing strategy that he will follow religiously.
His strategy is simple but very powerful if followed through. He decided to revisit his portfolio once at the end of every quarter and readjust the weights of his assets to the above target allocation.
In his first quarter of investing, Jim’s asset allocation deviated from the target allocation as shown below:
In green, we have his target allocation (what he started with) and in yellow is his allocation at the end of the first quarter (three months after he started).
To get a general idea of what happened, we can look at the overall risky vs safe allocation by adding all assets within each category. In this example, we see that the current allocation is skewed towards risky assets because their allocation went from 40% to 46%, and the opposite happened to the safe assets, as their allocation decreased to 54%. This is due to the risky assets generating higher returns than the safer assets.
This change may be a problem because it can bring certain undesired risks in the future, so Jim decided to follow his strategy and rebalance the portfolio by selling some risky assets and buying safe ones.
Jim will have to sell 6% (40% – 46% = -6%) of his risky asset portion, and buy 6% (60% – 54% = +6%) of his safer asset portion.
Now, let’s see how he will go about actually performing the necessary rebalancing for the quarter:
Even though the above may seem intimidation, it is actually really easy to understand if you follow like by line and step by step.
Let’s dissect the first line, stocks:
- His target allocation is 30% which is $600 of his total of $2,000 initially invested.
- The value at the end of the 1st quarter of his stocks increased to $805, or 35% of his total investment.
- He calculated that he needed to sell 5% of his stock allocation (30% target – 35% current), which is -$115 (-5% rebalance x $2,300 current total value)
- He sold $115 worth of stock to get back to his target allocation of 30%
- Then, he repeated this process with all his assets to achieve a fully rebalanced portfolio.
There are multiple rebalancing strategies that work fairly well at maintaining a good portfolio strategy. However, we believe that our dynamic rebalancing strategy takes the best out of the most important strategies and combines it into one simple and amazing process. It combines three elements that will ultimately ensure you get the best returns for the risk you want at all times.
In the next section, we will discover what brokers are, how to find the best brokers for you and how a typical account setup works.