If you—as an investor—decide to construct a portfolio, upon what principles will your overall asset selection process go about? For most investors, the fundamental principle is that the portfolio should reflect their individual risk tolerance. This is obviously different for everyone depending on the circumstances and needs of the investor, but the basic idea remains the same.
However, once a balanced portfolio with the desired level of asset allocation is achieved, should you just set it and forget it? No, that is quite risky in itself, considering the volatile and unpredictable nature of the market. To solve these changes and to ensure that asset weightages are realigned in accordance with the basic goals of the investor, the portfolios have to be rebalanced.
In this article, we will look at the concept of portfolio rebalancing, how investors can go about doing it, and why it is important.
Definition of Portfolio Rebalancing
A fundamental confusion that may arise when one hears of this concept is what exactly it refers to. An initial portfolio is usually balanced between the investment goals of the investor and their desired risk. An issue, however, arises when due to price fluctuations, among other reasons, certain investments underperform whilst some over perform.
There is, then, a need to rebalance the investment portfolio in order to maintain balanced levels of risk. This rebalancing can be done when your asset allocation has deviated quite significantly from what you would ideally want or at time intervals decided at a prior date.
Why is Rebalancing Important
There are a number of reasons why rebalancing a portfolio may be considered very important. The basic reason why rebalancing of portfolios is done is to achieve a proportional balance between the return and risk potential of an investment portfolio.
It helps to establish a healthier risk control and allows investors to avoid being singularly dependent on particular types of asset classes or funds. It also ensures that the portfolio remains within the manager’s area of expertise and doesn’t become too overly difficult or volatile to manage.
Example: As an example, if your portfolio has a simple 50/50 division between stocks and bonds, then that is your ideal asset allocation. If stocks begin performing well, the balance may tip in their favor and increase their price to the extent that the stock values increase and their proportion in the portfolio increases as well.
This would unbalance the portfolio since the risk initially spurred for the stocks has now increased due to the increase in value. To rebalance this portfolio, the investor would sell their stocks and use the proceeds to buy more bonds. This would help rebalance the asset allocation and return the portfolio to its initial 50/50 balance.
Of course, it isn’t necessary that the allocation would be done on such a basis and could, of course, be differentiated into any number of proportions depending on the risk tolerance and goals of the investor.
How does Rebalancing Help Investors
This is a very good question, and its answer lies within the conceptual definition and understanding of the importance of portfolio rebalancing. Investors require rebalancing skills in order to minimize their risks and keep their portfolios aligned with their overall investment goals.
Additionally, they need to remain cognizant of their portfolio asset allocations in order to change them when they feel that their portfolio should adapt to changing individual circumstances. For this reason, rebalancing helps investors and creates a generally stress-free climate for investors.
How do you Rebalance your Portfolio?
Continuing the example given above, when you rebalance your portfolio, you can sell the proceeds from your overweight stocks and use them to invest in more bonds in order to rebalance the initial proportions. You could either sell your stock investments and use them to buy more bonds, or you could invest strategically in different bonds through external cash influx, allowing you to maintain the profitability of your winning stock holding. The two basic options to rebalance your portfolio are:
Sell High, Buy Low
This common adage has a somewhat different meaning in this context. The reason for this is that in order to rebalance, the investor sells their well-performing stock and uses the proceeds to invest in low-performance securities and bonds; this is a traditional way of rebalancing portfolios and requires you to sell your highest-performing assets.
You can, of course, also do strategic allocation in order to rebalance your portfolio without actually getting rid of your high-performing stocks. The way to do this is by strategically investing new money into low-performing securities etc., until your portfolio is balanced out.
This approach is favored to the former since it does not require the sacrifice of the high-performance stock, allowing the investor to adapt to the situation and invest in new stocks whilst also keeping a balanced portfolio.
How should you go about Rebalancing
There are a variety of different ways which you can use in order to rebalance your portfolio. If you are generally well-off and do not have a very strong aversion to risks, or if you treat the stock market as a supplementary income, then you can use fun ways such as Rule110 to set your portfolio balances.
This means you subtract your age from 110 and invest the answer into stock holdings. However, investors generally have a number of financial considerations in place before they balance their portfolios in a particular way. If you’re generally risk-tolerant and believe that your individual circumstances allow for the accommodation of risks, you can invest more in stocks.
The reason for this is that your portfolio would then be centered around securities that allow for greater profit potential but also greater risk due to market fluctuations and volatility. If, however, you do value the risk factor and wish for a sustainable model of portfolio balancing which accommodates your individual need for risk minimization, you can shift to bond investors or even cash.
In addition to such generalities, there is also an interesting link between tax harvesting strategies and rebalancing. They can be linked in a way whereby taxable accounts experience the benefits of a tax-optimization strategy while also adding value to the rebalancing. In this way, many investors and wealth companies look for tax-harvesting opportunities while rebalancing.
At the end of the day, there are different ways and solutions to this question, and they all depend on the fact that the individual must take their own financial circumstances into account.
The long-term benefit of Rebalancing
We have seen the different facets of how rebalancing of portfolio happens and why it is important. In this section of the article, we will be looking at a major long-term benefit of portfolio rebalancing to stock market investors. The advantage here is essential that having a diversified yet constantly balanced portfolio disincentivizes investors from falling to the sway of emotional outbursts within the stock market.
This advantage essentially focuses on the idea that investors generally act on emotional impulse and irrational thinking during times of market plunges and highs; they may completely discard the adage of buying low and selling high, instead opting to try their luck at benefitting from the volatile sways of the stock market.
Rebalancing portfolios regularly helps avoid this since the investor can make rational decisions that align with the goal of maintaining the proportionality of the portfolios. This may include, for example, at times of stock market crashes which lead to drops in equity and rise in bond values, the investor opting to sell high-performing bonds and buying low-performing stocks instead of in order to balance out the portfolio. This would, of course, help the investor in maintaining a sustainable portfolio model in the long run.
Costs of Rebalancing
Now we look at the potential costs of rebalancing a portfolio. We will analyze all the different costs involved in rebalancing in this part of the article and attempt to explain the implications of this to the investor. There are a number of costs associated with rebalancing, including:
These are the costs of buying and selling securities in order to maintain a particular portfolio balance, and so are an inevitable part of your overall costs. They generally include the brokerage costs and the Security Transaction Taxes (STT).
To minimize transaction costs and taxes, you have room to maneuver, and therefore you can partially rebalance your portfolio through systematic divesting and investing. This means that you can focus on various different asset classes that have an above-average cost basis.
In general, however, focusing only on largely overweight or largely underweight securities will, at least to an extent, limit the tax and transaction fees associated with rebalancing.
Taxation on Capital Gains
There is taxation incurred upon the equity investments you sell within a year on capital gains of those equities. In addition to this, a marginal tax can also be implemented upon debt investments which you may plan on selling within a three-year span of time.
To counter this, you can rebalance within your tax-advantaged accounts only since selling investments from a taxable account would incur capital gains tax as well.
At RVW Wealth, some of these costs are minimized since your services are personalized, and your costs, therefore, are not volatile or subject to change due to changes in plans or market sway.
When should you Rebalance your Portfolio?
We have now looked at what Portfolio Rebalancing is, what its implications and importance are, how rebalancing can be done and its different ways, the long-term benefit of rebalancing, and the costs that are associated with this technique.
Now, a burning question for any potential investor would be: when should I rebalance my portfolio? The answer to this is quite similar to the answer of how proportions should be decided; that is, it depends on the disposition of the individual investor and the type of portfolio which they have constructed.
Normally, many wealth firms would advise investors that a predetermined 6-month time interval may be a healthy way to monitor your portfolio and ensure that it is rebalanced on a regular basis. However, this interval can be extended to a year or shortened to 3-months or less depending on the type of portfolio which has been balanced out in the first place.
What this precludes, of course, is the disposition of the investor towards risk-tolerance when it comes to their portfolio. It is, however, generally advisable that a portfolio be rebalanced when the portfolio itself experiences sways of about 3-5% from its initial balanced position. Either that, or there shouldn’t be a predetermined date at all, and an investor can go ahead and do the rebalancing when it becomes clear that the current state of the portfolio is largely unbalanced and has created huge risks for the investor.
One thing that should become very clear after reading this article is that Portfolio Rebalancing is not a strategy that is fixed in stone. In fact, it can be regarded as a framework within which many portfolio diversifications and construction strategies constitute themselves.
In this way, it is an approach with a wide array of possible uses and more about identifying what suits you rather than going for what someone else is doing. It allows for a personalized portfolio that prioritizes the individual requirements of different investors and creates opportunities for them to use a system of rebalancing in order to ensure that their portfolio stays aligned with their investment goals and risk toleration.
September 24, 2021