If you have an investment portfolio, it’s important to understand the concept of rebalancing and how to do it correctly.
Rebalancing is the process of returning your portfolio to its original asset allocation mix.
There are a few reasons why you might want to rebalance: to maintain your desired risk level, to take profits in winning investments and redeploy them into weaker ones, or to restore your original target asset allocation after experiencing large market movements.
In this guide, we will teach you everything you need to know about rebalancing your portfolio!
What is portfolio rebalancing?
Portfolio rebalancing is the process of bringing your asset allocation back in line with your original investment goals.
This usually involves selling some assets that have increased in value and using the proceeds to buy other assets that have not performed as well.
During a period when the stock market is doing well, your portfolio may become “unbalanced” because the value of your stocks has increased more than the value of your bonds.
When this happens, you may want to “rebalance” your portfolio by selling some of your stocks and using the proceeds to buy more bonds. This will help you get back to your original asset allocation and reduce your risk.
Let’s see what this would look like using the traditional 60/40 portfolio (60% stocks / 40% bonds) with $100,000 invested as a starting point.
That means you’d have $60,000 in stocks and $40,000 in bonds.
If the stock value reaches $150,000 and the bonds only grow to $50,000, you’d have a portfolio weighting of 75% stocks and 25% bonds.
This would result in an unbalanced portfolio because you are heavily weighted towards stocks.
To rebalance, you would need to sell some of your stocks and use the proceeds to buy more bonds. This would bring your portfolio back to the original 60/40 asset allocation.
Rebalancing can be a difficult task, but it is important to keep your portfolio in line with your investment goals.
By regularly rebalancing your portfolio, you can help reduce your risk and keep your investments on track.
Why do you need to rebalance your portfolio?
There are a few reasons why an investor might want to rebalance their portfolio. Over time, different asset classes will outperform others.
For example, during periods of economic expansion, stocks will typically outperform bonds.
However, during periods of recession or market turmoil, bonds tend to do better than stocks.
If you don’t rebalance your portfolio, the percentage of your portfolio that is allocated to each asset class will change.
Let’s imagine you originally intended Bitcoin to only be a 10% allocation. But then it enters a bull market and reaches 60% of your portfolio.
You might be excited about the gains but it also means that a majority of your portfolio is now in a very volatile asset.
This can be detrimental if Bitcoin then crashes as you could lose a large chunk of your portfolio.
This hypothetical situation should paint a visual picture of the importance of periodically rebalancing your portfolio back to its original target allocations.
Let’s explore some more reasons why you need to rebalance your portfolio.
Reason To Rebalance #1 – Take Profits
The first is that it forces you to sell high and buy low.
This might seem counterintuitive, but it’s actually a really good way to make sure you’re buying assets when they’re undervalued and selling them when they’re overvalued.
By taking profits from higher risk overvalued assets, you can realise your profits and have the capital to allocate towards undervalued assets.
For example, if a stock goes up 100%, you could sell half of your position and take your original money out and let the rest stay invested.
You would then be able to use that capital to buy other assets that may be undervalued.
By repeating this process, you can help to ensure that your portfolio is always allocated towards relatively undervalued assets.
This strategy can also be applied to different asset classes.
For example, if you think stocks are overvalued and bonds are undervalued, you could sell some of your stocks and use the proceeds to buy bonds.
Reason To Rebalance #2 – Helps Investors To Stick With The Plan
The second reason is that it helps you stay disciplined.
It’s easy to get emotional about investing, and if you let your emotions guide your decisions, you’re more likely to make bad investment choices.
Rebalancing forces you to stick to your investment plan and makes sure you don’t get too excited or too worried about any one particular security.
Reason To Rebalance #3 – Risk Management
The third reason is that it helps you manage risk.
If you have a well-diversified portfolio, rebalancing can help you make sure that your portfolio stays diversified.
This is because as different asset classes move up and down in value, your allocation to each asset class will change.
By rebalancing your portfolio, you can help make sure that your portfolio stays diversified and that you are taking the appropriate amount of risk for your investment goals.
Reason To Rebalance #4 – Different Goals
Another reason to rebalance is when an investor’s goals or time horizon changes.
For example, someone who is saving for retirement might have a portfolio that is heavily weighted towards stocks.
As they get closer to retirement, their risk appetite may change and they might want to rebalance their portfolio to include more bonds and other fixed-income investments which tend to be less volatile.
Reason To Rebalance #5 – Investment Thesis Has Changed
The final reason to rebalance is when an investor’s investment thesis has changed.
This could be because the original investment no longer meets their criteria or because they have found a new investment that they believe will outperform their current holdings.
For example, an investor who originally bought a stock because it was undervalued may want to sell it if the company’s financials and competitive advantage deteriorate.
An investor who is bullish on the future of a particular industry may want to allocate heavier to it.
An example of this would be if global adoption of cryptocurrencies accelerates and governments begin to support it.
If any of these reasons apply to you, then it may be time to consider rebalancing your portfolio.
But how often should you rebalance?
And how do you know when to rebalance?
These are important questions that we will answer in the next section.
When should you rebalance?
The answer to this question depends on a few factors, including your investment goals, time horizon, and risk tolerance.
If you have a long-term investment horizon, you may not need to rebalance as often because you will have more time to recover from any short-term losses.
On the other hand, if you have a shorter time horizon or are risk-averse, you may want to rebalance more frequently to help reduce the impact of volatility on your portfolio.
It’s also important to consider taxes when deciding how often to rebalance. If you are selling assets that have appreciated in value, you may be subject to capital gains taxes.
This is something that you should speak to your financial advisor and tax associate about before making any decisions.
For our Singaporean readers, this part isn’t applicable as capital gains from investing aren’t taxable.
However, it’s generally a good time to consider rebalancing when:
- You experience a major life event (marriage, divorce, birth of a child, etc.)
- Your asset allocation gets too far away from your target allocation
- You have a change in your investment goals or time horizon
- There is a significant change in the economic environment
- You need to raise cash for expenses
- Your investment thesis has changed
These are just a few examples, but they should give you a good idea of when it may be time to rebalance your portfolio.
It can also be helpful to understand when rebalancing might not be necessary.
Here’s when you shouldn’t rebalance your portfolio:
- You are invested in tax-advantaged accounts
- Your investment strategy is working
- You’re afraid of missing out
- You are impatient
- You’re bored
As you can see, tinkering and rebalancing your portfolio too often can actually lead to worse performance.
This is because it incurs transaction costs, and taxes, and can cause you to miss out on potential gains.
So, if your investment strategy is working and you’re happy with your performance, there’s no need to make any changes.
Of course, this doesn’t mean that you should never rebalance your portfolio. As we’ve seen, there are certain times when it makes sense to do so.
The best time to rebalance your portfolio is when there is a strategic reason for doing so, preferably when tax consequences are minimal.
Many financial advisors and experienced investors recommend checking for the above every 3-6 months or just generally rebalance them every 3-6 months.
By understanding when to rebalance, you can help ensure that your portfolio is well-positioned to achieve your long-term investment goals.
How to rebalance my portfolio?
The answer to that question is not as simple as it may seem.
There are a variety of ways to rebalance your portfolio, and the method you choose should be based on your specific goals and circumstances.
Sell & Buy Assets
One common way to rebalance is to simply sell off the assets that have increased in value and use the proceeds to buy more of the assets that have lost value.
This ensures that your portfolio remains diversified and reduces your overall risk.
Another way to rebalance is to set target percentages for each asset class and then periodically buy or sell assets to maintain those targets.
For example, if you want your portfolio to be 60% stocks and 40% bonds, you would sell stocks when they exceed 60% of the total value and buy stocks when they fall below that level.
Take note that it’s not as simple as it seems, but still relatively easy.
Assuming that you have $100,000 invested, with 60% in stocks and 40% in bonds.
Now the value of stocks goes up to $90,000 and your bonds increase to $50,000.
With $140,000 in value, your ratio is now approximately 64%:36%.
However, selling $30,000 worth of stocks to bring it back to $60,000 will throw off the balance as you’ll now have $60,000 in stocks vs $50,000 in bonds.
That makes it a 55%:44% ratio.
Thus, you’ll need to recalculate how much stocks you’ll need to sell.
Using the same example, $140,000 is now 100%.
Hence, to rebalance into the same ratio, you’ll need $84,000 (60%) worth of stocks and $56,000 (40%) worth of bonds in your portfolio.
Therefore, you’ll only need to sell $6,000 worth of stocks and use the profits to purchase bonds!
Rebalancing by Contribution
You can also add more money from other sources of income to increase the weighting of an asset class that has lost value.
This is known as “rebalancing by contribution.”
This is helpful because it means that you don’t have to sell a position if you believe it will continue to go up in value.
You can let your winners ride while supporting and even lowering your average cost basis for your losers.
Now, this is a little bit more challenging and will require more calculations.
Using the same example above;
With $90,000 in stocks and $50,000 in bonds, your ratio now is 64% and 36% respectively.
This method requires you to add cash into the asset that is not in the desired proportions – bonds.
Since stocks should be 60%, $90,000 = 60%.
Therefore, 40% is $60,000.
This means you need $60,000 in bonds to rebalance your portfolio, so simply take $60,000 – $50,000, and you’ll know you need to top up $10,000 into bonds!
Which Rebalancing Method Should You Choose?
This depends, do you have more to invest? If you have, you can opt for the latter.
Otherwise, selling & buying assets is your only option.
However, having more money to invest doesn’t justify adding more money in your portfolio.
If you’re a more advanced investor, you can look at macroeconomic conditions, market trends, and new investment opportunities.
If you want to remain a more passive investor, either method is fine.
What’s important is that when rebalancing, it is important to keep costs low.
Selling and buying assets incur transaction costs, which can eat into your returns.
Calculate how much you’ll incur in fees for each buy and sell trade on your broker so that you know how much you’re paying.
As mentioned earlier, don’t forget about taxes! When you sell assets, you may owe capital gains taxes on the profits.
Be sure to factor this into your rebalancing strategy so you don’t end up with an unexpected tax bill down the road.
How to minimise taxes when rebalancing?
Singaporean readers, you can skip this section.
When it comes to portfolio rebalancing, minimising your tax bill should be a key consideration.
There are a few different ways to do this, and the method you choose will depend on your personal circumstances.
One option is to sell assets that have lost money since you purchased them, and use the losses to offset any gains from selling other assets.
This is known as tax-loss harvesting, and it can be an effective way to minimise your tax bill.
Another option is to sell assets that are located in a high-tax jurisdiction and use the proceeds to purchase assets in a lower-tax jurisdiction.
This can be a complex manoeuvre, so it’s important to seek professional advice before proceeding.
Finally, you may want to consider using the strategy of “rebalancing by contribution.” This can be the best way as there will be no taxes for selling and buying.
With this strategy, you simply contribute money to the investment that is lagging behind and let the other investment continue to grow without selling it.
Ultimately, the decision of whether or not to rebalance your portfolio is a personal one.
There is no right or wrong answer, and there is no perfect strategy that will work for everyone.
The method you choose should be based on your specific goals and circumstances.
By periodically rebalancing, you can help reduce your overall risk and keep your portfolio diversified.
However, it is important to remember that rebalancing incurs transaction costs and may result in capital gains taxes.
Be sure to factor these costs into your rebalancing strategy.
The most important thing is to have a plan and stick to it. Rebalancing is not something you should do on a whim; it should be a deliberate, systematic process.
If rebalancing seems like it’s too complicated for you, it’s better to invest via a financial advisor.
They can help you develop an investment plan that’s tailored to your unique situation, and help you with everything you’ll need with regard to investing.