Rebalancing portfolios will help investors weather the storms of the market
Creating a good investment portfolio is an art and a science. However, “set and forget” is not enough to achieve the long-term investment goal. The portfolio becomes unbalanced over time, and the weightings of asset classes and sub-asset classes fluctuate and change due to market movements. The result is that allocations deviate from the ideal asset mix, which changes the risk-return profile of the portfolio. Rebalancing involves bringing the portfolio back to the desired asset mix aligned with the investor’s risk-return profile.
Depending on investment returns, the weighting of each asset class is expected to change, altering the risk profile of the portfolio. Rebalancing helps keep risk within the desired limit. It ensures that the portfolio is not solely dependent on the success or failure of a particular investment, asset class or type of fund. This helps avoid over-reliance on emotions when making important investment decisions and brings discipline. It helps to align the investment with the objectives by periodically rebalancing the portfolio. Rebalancing helps to control portfolio drifts. These drifts may not be obvious as they may occur gradually. If you don’t pay regular attention to it, you can skew the asset mix and expose yourself to more risk.
An important question is when and how to rebalance? It is required when there is a significant change in the composition of the asset compared to the original and/or there is a change in the risk profile of an investor and/or when an investor is closer to the target. There are several methods to rebalance. An investor can either set a frequency at which they will continuously assess the current state of portfolio allocation, or set asset allocation ranges. In periodic (time-based) rebalancing, investors set a schedule and rebalance the portfolio based on that time frame. For example, every 12 months measure the actual mix of investments against the target. Depending on the variation, decide whether to make changes or wait another year to rebalance. In tolerance band (percentage-based) rebalancing, investors set specific thresholds that, if breached, trigger rebalancing.
This approach means the investor needs to monitor allocations more frequently than periodic rebalancing, which may only require an annual portfolio check. One can also consider a combination strategy, using both periodic and annual rebalancing with tolerance bands.
By selling high performing investments and buying underperforming investments, rebalancing can be achieved. It can also be done strategically by using other buys and sells to rebalance. Investors often make regular payments or withdrawals to the portfolio which can help them rebalance at a lower cost. One should be aware of the cost involved when rebalancing. The impact of capital gain, exit fees and brokerage fees have an impact on the cost of rebalancing.
We plan, design and execute. But things may not go according to our plan. This is where rebalancing comes in. Portfolio construction matters a lot, but not rebalancing. Rebalancing ensures that the portfolio and strategy remain relevant and helps the portfolio survive the tides of different market cycles and helps achieve the long-term investment objective.
(The author is co-founder and partner, Fintrust Advisors LLP)