So you've established an asset allocation strategy that is right for you, but at the end of the year, you find that the weighting of each asset class in your portfolio has changed! What happened? Over the course of the year, the market value of each security within your portfolio earned a different return, resulting in a weighting change. Portfolio rebalancing is like a tune-up for your car: it allows individuals to keep their risk level in check and minimize risk.

What Is Rebalancing?
Rebalancing is the process of buying and selling portions of your portfolio in order to set the weight of each asset class back to its original state. In addition, if an investor's investment strategy or tolerance for risk has changed, he or she can use rebalancing to readjust the weightings of each security or asset class in the portfolio to fulfill a newly devised asset allocation.

Blown Out of Proportion
The asset mix originally created by an investor inevitably changes as a result of differing returns among various securities and asset classes. As a result, the percentage that you've allocated to different asset classes will change. This change may increase or decrease the risk of your portfolio, so let's compare a rebalanced portfolio to one in which changes were ignored, and then we'll look at the potential consequences of neglected allocations in a portfolio.

Let's run through a simple example. Bob has $100,000 to invest. He decides to invest 50% in a bond fund, 10% in a Treasury fund and 40% in an equity fund.

140503_1.GIF

At the end of the year, Bob finds that the equity portion of his portfolio has dramatically outperformed the bond and Treasury portions. This has caused a change in his allocation of assets, increasing the percentage that he has in the equity fund while decreasing the amount invested in the Treasury and bond funds.

140503_2.GIF

More specifically, the above chart shows that Bob's $40,000 investment in the equity fund has grown to $55,000, an increase of 37%! Conversely, the bond fund suffered, realizing a loss of 5%, but the Treasury fund realized a modest increase of 4%. The overall return on Bob's portfolio was 12.9%, but now there is more weight on equities than on bonds. Bob might be willing to leave the asset mix as is for the time being, but leaving it too long could result in an overweighting in the equity fund, which is more risky than the bond and Treasury fund. (Learn more about the relative risk of various investments in Determining Risk And The Risk Pyramid.)

The Consequences Imbalance
A popular belief among many investors is that if an investment has performed well over the last year, it should perform well over the next year. Unfortunately, past performance is not always an indication of future performance - this is a fact many mutual funds disclose. Many investors, however, remain heavily invested in last year's "winning" fund and may drop their portfolio weighting in last year's "losing" fixed-income fund. Remember, equities are more volatile than fixed-income securities, so last year's large gains may translate into losses over the next year.

Let's continue with Bob's portfolio and compare the values of his rebalanced portfolio with the portfolio left unchanged.

140503_3.GIF

At the end of the second year, the equity fund performs poorly, losing 7%. At the same time the bond fund performs well, appreciating 15%, and Treasuries remain relatively stable with a 2% increase. If Bob had rebalanced his portfolio the previous year, his total portfolio value would be $118,500, an increase of 5%. If Bob had left his portfolio alone with the skewed weightings, his total portfolio value would be $116,858, an increase of only 3.5%. In this case, rebalancing is the optimal strategy.

140503_4.GIF

However, if the stock market rallies again throughout the second year, the equity fund would appreciate more and the ignored portfolio may realize a greater appreciation in value than the bond fund. Just as with many hedging strategies, upside potential may be limited, but, by rebalancing, you are nevertheless adhering to your risk-return tolerance level. Risk-loving investors are able to tolerate the gains and losses associated with a heavy weighting in an equity fund, and risk-averse investors, who choose the safety offered in Treasury and fixed-income funds, are willing to accept limited upside potential in exchange for greater investment security. (Determine your risk tolerance in Personalizing Risk Tolerance.)

How to Rebalance Your Portfolio
The optimal frequency of portfolio rebalancing depends on your transaction costs, personal preferences and tax considerations, including what type of account you are selling from and whether your capital gains or losses will be taxed at a short-term versus long-term rate. Usually about once a year is sufficient; however, if some assets in your portfolio haven't experienced a large appreciation within the year, longer time periods may also be appropriate. Additionally, changes in an investor's lifestyle may warrant a change to his or her asset-allocation strategy. Whatever your preference, the following guideline provides the basic steps for rebalancing your portfolio:

  1. Record - If you have recently decided on an asset-allocation strategy perfect for you and purchased the appropriate securities in each asset class, keep a record of the total cost of each security at that time, as well as the total cost of your portfolio. These numbers will provide you with historical data of your portfolio, so at a future date you can compare them to current values.
  2. Compare - On a chosen future date, review the current value of your portfolio and of each asset class. Calculate the weightings of each fund in your portfolio by dividing the current value of each asset class by the total current portfolio value. Compare this figure to the original weightings. Are there any significant changes? If not, and if you have no need to liquidate your portfolio in the short term, it may be better to remain passive.
  3. Adjust - If you find that changes in your asset class weightings have distorted the portfolio's exposure to risk, take the current total value of your portfolio and multiply it by each of the (percentage) weightings originally assigned to each asset class. The figures you calculate will be the amounts that should be invested in each asset class in order to maintain your original asset allocation. You may want to sell securities from asset classes whose weights are too high, and purchase additional securities in asset classes whose weights have declined. However, when selling assets to rebalance your portfolio, take a moment to consider the tax implications of readjusting your portfolio. In some cases, it might be more beneficial to simply not contribute any new funds to the asset class that is overweighted while continuing to contribute to other asset classes that are underweighted. Your portfolio will rebalance over time without you incurring capital gains taxes.

Conclusion
Rebalancing your portfolio will help you maintain your original asset-allocation strategy and allow you to implement any changes you make to your investing style. Essentially, rebalancing will help you stick to your investing plan regardless of what the market does. (To learn more, read Achieving Optimal Asset Allocation.)

Related Articles
  1. Investing News

    Negative Interest Rates and QE: 3 Economic Risks

    Along with quantitative easing (QE), unconventional monetary tools are meant to stimulate economic activity, growth, and a moderate level of inflation.
  2. Investing Basics

    Contingent Convertible Bonds: Bumpy Ride Ahead

    European banks' CoCos are in crisis. What investors who hold these high-reward but high-risk bonds should know.
  3. Mutual Funds & ETFs

    The 3 Best T. Rowe Price Funds for Value Investors in 2016

    Read analyses of the top three T. Rowe Price value funds open to new investors, and learn about their investment objectives and historical performances.
  4. Active Trading Fundamentals

    4 Stocks With Bullish Head and Shoulders Patterns for 2016 (PG, ETR)

    Discover analyses of the top four stocks with bullish head and shoulders patterns forming in 2016, and learn the prices at which they should be considered.
  5. Investing

    3 Healthy Financial Habits for 2016

    ”Winning” investors don't just set it and forget it. They consistently take steps to adapt their investment plan in the face of changing markets.
  6. Investing

    How to Ballast a Portfolio with Bonds

    If January and early February performance is any guide, there’s a new normal in financial markets today: Heightened volatility.
  7. Fundamental Analysis

    3 Reasons To Not Sell After a Market Downturn

    Find out the reasons that it is not a good idea to sell after a market downturn. There are lessons to be learned from the last major market downturn.
  8. Fundamental Analysis

    HF Performance Report: Did Hedge Funds Earn Their Fee in 2015?

    Find out whether hedge funds, which have come under tremendous pressure to improve their performance, managed to earn their fee in 2015.
  9. Sectors

    2016's Most Promising Asset Classes

    Find out which asset classes are considered to be the most promising for generating portfolio returns and reducing volatility in 2016.
  10. Mutual Funds & ETFs

    3 Morgan Stanley Funds Rated 5 Stars by Morningstar

    Discover the three best mutual funds administered and managed by Morgan Stanley that received five-star overall ratings from Morningstar.
RELATED FAQS
  1. What is a derivative?

    A derivative is a contract between two or more parties whose value is based on an agreed-upon underlying financial asset, ... Read Full Answer >>
  2. What's the difference between a stop and a limit order?

    Different types of orders allow you to be more specific about how you'd like your broker to fulfill your trades. When you ... Read Full Answer >>
  3. Are secured personal loans better than unsecured loans?

    Secured loans are better for the borrower than unsecured loans because the loan terms are more agreeable. Often, the interest ... Read Full Answer >>
  4. How liquid are Vanguard mutual funds?

    The Vanguard mutual fund family is one of the largest and most well-recognized fund family in the financial industry. Its ... Read Full Answer >>
  5. Which mutual funds made money in 2008?

    Out of the 2,800 mutual funds that Morningstar, Inc., the leading provider of independent investment research in North America, ... Read Full Answer >>
  6. How do mutual funds work in India?

    Mutual funds in India work in much the same way as mutual funds in the United States. Like their American counterparts, Indian ... Read Full Answer >>
Hot Definitions
  1. Harry Potter Stock Index

    A collection of stocks from companies related to the "Harry Potter" series franchise. Created by StockPickr, this index seeks ...
  2. Liquidation Margin

    Liquidation margin refers to the value of all of the equity positions in a margin account. If an investor or trader holds ...
  3. Black Swan

    An event or occurrence that deviates beyond what is normally expected of a situation and that would be extremely difficult ...
  4. Inverted Yield Curve

    An interest rate environment in which long-term debt instruments have a lower yield than short-term debt instruments of the ...
  5. Socially Responsible Investment - SRI

    An investment that is considered socially responsible because of the nature of the business the company conducts. Common ...
Trading Center