Portfolio Balancing and Rebalancing

A Guide to Asset Diversification and Growth

Portfolio Balancing and Rebalancing
February 19, 2014

What does it mean to balance or rebalance your portfolio? It means you currently have a ratio of different types of assets (stocks, bonds, cash, etc.) in your investment portfolio that might need to be changed to fit your current or upcoming objectives.

Whenever you first establish -- or periodically rebalance – your asset allocation, start by determining your tolerance for risk and volatility. Then focus on your investment goals. Ask yourself the following questions: Are you investing for twenty or forty years? Can you resist the urge to chase hot stocks or dump underperforming stocks based only on short-term results? Can you tolerate watching your portfolio drop significantly in the short-term? The answers will tell you how far to deviate from a typical portfolio mix.

What is the typical portfolio mix? It varies with age and the amount of money you need to accumulate for retirement, but a good guess is to use your age as the percentage of conservative investments (bonds/cash) to hold. If you are 25 years old, start with a 75% stocks/25% bonds ratio, and if you're 75, vice versa. Deviate according to your situation – for example, if you are starting late, you will need to maintain a higher ratio of stocks to catch up. This will set your starting portfolio balance.

The principle is to take more risks early, and move to conservative, less volatile assets closer to retirement when a short-term dip in stocks could wipe out gains before you can earn them back.

There are two typical reasons to rebalance a portfolio:

  • Changed Needs – As your life circumstances change, you will want to rebalance the portfolio to reflect a new preferred ratio.

  • Changed Asset Value – If the values of your assets have changed disproportionately over time, you need to adjust the ratio. For example, let's say that your stocks have done extremely well in the past year and your bond funds have tanked, so what started out, as a 75%-25% ratio is now 90%-10% at current prices.

    Are we suggesting you sell your best performing stocks and use them to buy bonds? Yes, some of them, to get back to your desired asset ratio. Look for undervalued bonds – or if there is valid reason to expect your current bonds to bounce back, buy some more. It may seem to defy logic, but remember, you gain using the old "buy low, sell high" philosophy.

When rebalancing your portfolio, take into account the following issues:

  • Correlation of Assets– Correlation refers to how well the historical performance of two investments tracks. A correlation of -1 means that their prices move in opposite directions; +1 means that their prices move in unison; and 0 means there is no correlation. To stay diverse and keep your risks down, you want a correlation fairly close to zero. Correlation information and calculators may be found online.

  • Transaction Fees and Other Costs – If you rebalance your portfolio too often, you risk racking up too many transaction fees and other charges. Reviewing and rebalancing once a year is adequate for most investors.

  • Asset Concentration – You should avoid excessive concentration in any one type of asset – i.e., capitalization (small vs. large cap stocks), sectors (technology, energy, etc.), geography (international vs. domestic), etc. If you follow typical rules of correlation and asset allocation, this should take care of itself – but it's wise to review your level of diversification.

Portfolio rebalancing is all about maintaining the best risk/reward balance as you pursue growth over the long term. By following a consistent rebalancing policy and timetable, you should stay fiscally sound and be able to enjoy the fruits of your investing discipline in the golden years of your retirement.

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