Understanding portfolio rebalancing is critical to reducing investor risk and meeting long-term goals.
A yoga master may tell you that aligning your “chakras” (the energy points or nodes in a “subtle body,” according to yogic tradition) on a regular basis will keep you healthy and happy. The same advice can apply to your portfolio strategy.
Portfolio rebalancing refers to the periodic shuffling of stocks, bonds, and other assets to maintain certain proportions (60% stocks, 40% bonds, for example). It’s critical to your “core” financial strength in part because it helps reduce risks of overexposure to any particular position. It can also be a psychological challenge, because it forces you to say goodbye to some of your star performers and welcome more of the lesser lights.
Here are a few things to consider.
When you first set out allocating, you likely considered your age and life stage, your needs and those of your family, your risk tolerance, and other factors. Then you identified a mix of stocks, bonds, cash, and other investments that reflected you as an investor. As time goes by, asset values change. They grow (hopefully) or shrink, depending on what the markets do.
Eventually, a portfolio becomes “unbalanced,” that is, over-allocated in one or more investments. For example, rising stock prices may push your equity allocation to 70%. That might appear welcome at first blush, but it leaves you susceptible to volatility spikes and bigger losses in certain assets.
Third Eye Blind?
You don’t need a third eye to see that market success comes down to buying low and selling high. Ideally, that’s what’s happening when you realign. Assets that have grown to a point of over-allocation may be at a higher price relative to recent history. Of course, that doesn’t mean the price won’t go even higher.
Still, don’t let yourself get caught up in mental games. By selling some of the strongest performers, you’re locking in gains, while still realizing benefits if prices should appreciate further. And if the asset declines, you’ll have limited the damage.
Flipping this around, think of the weaker members of your roster as being in need of a little coaching up. Lower-priced assets obviously cost less, meaning that gains from selling the strongest can be applied to scoop up more of what’s potentially undervalued (at a reduced average cost per trade). It’s possible prices may fall further, of course. But if the top and bottom performers eventually switch places, you stand to benefit.
A Modern Portfolio Theory Primer
Seeking to minimize risks while maximizing potential returns lies at the essence of investing strategy, and forms the basis of modern portfolio theory, or MPT.
Developed by Nobel Laureate Harry Markowitz, MPT suggests volatility in a portfolio can be limited and performance can be improved by spreading the risk among different types of securities that don't always behave the same way.
For various levels of risk, there is an “optimal” asset allocation that is designed to produce the best balance of risk versus return.
Balancing Yin and Yang
Timing is important in a lot of things. Which takes us to our next question: How often do you rebalance? Money managers traditionally rebalanced every quarter or every year. But research from Gobind Daryanani, a managing director at TD Ameritrade, suggests a more opportunistic approach—not necessarily locking yourself to the calendar, but keeping a close eye on how asset classes fall into certain “bands.”
What’s that mean? For example, suppose a portfolio started at 50% stocks, 40% bonds, and 10% cash, but after a 20% increase in the value of the stocks, the portfolio shifted to 60%/35%/5%. That 20% “band” (the percentage shift from the original allocation level) would be a signal that the portfolio is over-allocated in stocks and it’s time to rebalance. In terms of time intervals between rebalancing, Daryanani found the best performance at 20 trading days and 125 days.
That’s not to say you need to be logging into your account every 10 minutes, nor should you just set it and forget it. Be aware of your portfolio status and understand how real-world events can have an impact. Ultimately, the right rebalancing strategy boils down to what you’re comfortable with and your longer-term goals. Like a lot of things, it starts with mind over matter.
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