Portfolio Rebalancing -- Part 1: When’s the Last Time You “Mowed” Your Portfolio?
In our recent post on spring cleaning, we touched on the important role that rebalancing plays in maintaining your tidy investment portfolio, so it continues to reflect the landscape you’ve envisioned for your wealth. Like yard maintenance, you need to proactively rebalance your portfolio from time to time – pruning here, fertilizing there, according to your master plan. Otherwise, like a yard left untended, the market’s wild growth has a way of reconfiguring things for you, but probably not as you intended. Let’s explore that concept in greater detail.
How Rebalancing Works: The Big Picture
When we create your portfolio, we do so according to particular percentages defined in your personalized Investment Policy Statement (IPS). As the markets shift around, your investments tend to stray from their original, intended “weights” or allocations. Rebalancing is the process of shifting those allocations back where they belong. Having a process in place keeps your portfolio efficiently on track toward your personal goals, helps you manage your desired risk levels, and provides you with a disciplined approach for buying when prices are low and selling when prices are high.
To illustrate, imagine your portfolio is supposed to be half stocks and half bonds. When the stock market outperforms the bond market, you end up with too many stocks relative to bonds. You’re no longer at your intended 50/50 mix, with more risk–more stocks–in your portfolio than you intended. To rebalance, you sell some of the overgrown stocks (selling high), and use the proceeds to buy some thinned-out bonds (buying low), until you’re back at or near your desired mix. After periods when bonds have been significantly outperforming, you may need to do the reverse.
How Rebalancing Works: A Closer Look
Rebalancing does get a little more complicated than that, in that it’s a plural versus singular activity. First, you want to build a balance between stocks (higher risk, higher expected returns) versus bonds (lower risk, lower expected returns). Then you typically divide these broad assets among their subsets according to your unique financial goals and your risk “fingerprint.” For example, you can assign percentages of your stocks to small- vs. large-company and value vs. growth firms, and further divide these among international, U.S., and/or emerging markets.
The reason for these relatively precise allocations is to expose you to the right amount of expected market premiums for your personal goals, while managing the market risks involved by spreading them around the globe.
So far, so good. But just as our backyards (my own included!) rarely look as good as we imagine they could, rebalancing is often easier said than done. In our next post, we’ll explore some of the reasons why that’s so, and some tips on how to overcome the challenges.
