As we move into the last month of the year and look forward to the new year many of us look to get our financial situation in order. One of the most important things you can do is to ensure that your investments are properly allocated. Portfolio rebalancing is something that all investors should do periodically. Here are 4 benefits of portfolio rebalancing.
Balancing risk and reward
Asset allocation is about balancing risk and reward. Invariably some asset classes will perform better than others. This can cause your portfolio to be skewed towards an allocation that takes too much risk or too little risk based on your financial objectives.
During robust periods in the stock market equities will outperform asset classes such as fixed income. Perhaps your target allocation was 65% stocks and 35% bonds and cash. A stock market rally might leave your portfolio at 75% stocks and 25% fixed income and cash. This is great if the market continues to rise but you would likely see a more pronounced decline in your portfolio should the market experience a sharp correction.
Portfolio rebalancing enforces a level of discipline
Rebalancing imposes a level of discipline in terms of selling a portion of your winners and putting that money back into asset classes that have underperformed.
This may seem counter intuitive but market leadership rotates over time. During the first decade of this century emerging markets equities were often among the top performing asset classes. Fast forward to today and they are on track for their third year of losses.
Rebalancing can help save investors from their own worst instincts. It is often tempting to let top performing holdings and asset classes run when the markets seem to keep going up. Investors heavy in large caps, especially those with heavy tech holdings, found out the risk of this approach when the Dot Com bubble burst in early 2000.
Ideally investors should have a written investment policy that outlines their target asset allocation with upper and lower percentage ranges. Violating these ranges should trigger a review for potential portfolio rebalancing.
A good reason to review your portfolio
When considering portfolio rebalancing investors should also incorporate a full review of their portfolio that includes a review of their individual holdings and the continued validity of their investment strategy. Some questions you should ask yourself:
- Have individual stock holdings hit my growth target for that stock?
- How do my mutual funds and ETFs stack up compared to their peers?
- Relative performance?
- Expense ratios?
- Style consistency?
- Have my mutual funds or ETFs experienced significant inflows or outflows of dollars?
- Have there been any recent changes in the key personnel managing the fund?
These are some of the factors that financial advisors (hopefully) review as they review client portfolios.
This type of review should be done at least annually and I generally suggest that investors review their allocation no more often than quarterly so perhaps the full-blown portfolio review would not be done each time you do a rebalancing review.
Helps you stay on track with your financial plan
Investing success is not a goal unto itself but rather a tool to help ensure that you meet your financial goals and objectives. Regular readers of The Chicago Financial Planner know that I am a big proponent of having a financial plan in place.
A properly constructed financial plan will contain a target asset allocation and an investment strategy tied to your goals, your timeframe for the money and your risk tolerance. Periodic portfolio rebalancing is vital to maintaining an appropriate asset allocation that is in line with your financial plan.
The Bottom Line
Regular portfolio rebalancing helps reduce downside investment risk and ensures that your investments are allocated in line with your financial plan. It also can help investors impose an important level of discipline on themselves.