In today’s world, there is no such thing as a “set it and forget it” investment strategy. Even the most brilliant investors review their asset allocations periodically in an effort to mitigate risk and optimize their portfolio diversification. No matter how conservative your allocation may be, prices oscillate, markets move and economic landscapes evolve. As a result, asset values are forever changing, and it is crucial that investors take into account the effects these market fluctuations may have on their asset allocation; this is better known as rebalancing.
Rebalancing your portfolio is an elemental strategy when it comes to investing. Defined as realigning the weightings of one's portfolio of assets, it is important to make sure you are not over-allocated in any one asset class. This is simply 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, or target allocation. Using a conservative investor with an asset allocation consisting of 70% fixed income securities and 30% equity securities as an example, let’s assume the equity market has an unprecedented year and stocks rise in value across the board. As the investor’s equity positions rise in value, the aggregated allocation for their equity securities now make up 45% of the total portfolio. Although capital appreciation is always the goal, the portfolio’s allocation is now out of balance. As the original allocation calls for 30% equities and not 45%, the investor should rebalance in order to bring their asset allocation back to the designated target allocations.
Why You Should Rebalance Your Portfolio
There are many reasons why it is important to rebalance your portfolio on a regular basis. By incrementally rebalancing, you are able to capture the gains yielded from over-performing asset classes. In addition, rebalancing is key as it gives investors the opportunity to purchase under-performing asset classes while prices are low in hopes that they will be able to take advantage of that particular asset class’s future capital appreciation. (For related reading, see: The Role of Rebalancing.)
Not only are you protecting your upside, but you are reducing your potential downside as well. In reference to the aforementioned example, if you are over-allocated in equity holdings, you may be taking on far more risk than you had originally intended. Rebalancing your portfolio will bring your risk levels back to their original states.
How Often You Should Rebalance
The frequency by which an investor should rebalance their portfolio is very conditional and circumstantial. No two investors are the same and thus, their rebalancing practices will likely differ. Some investors rebalance on a fixed time-based schedule, for example, quarterly, semi-annually or annually. Other investors rebalance once they see their asset allocations have fallen out of line with their target allocations. It is important not to dwell on when you rebalance, as long as it is done every so often.
Rebalancing is a vital tool in maintaining the risk level within your investment portfolio. There are many inherent benefits, such as capturing capital gains, obtaining under-performing assets at low prices, optimizing portfolio diversification and resetting your portfolio to its original target allocations.
When was the last time you rebalanced your investment portfolio? Maybe you should go take a look today.
(For more from this author, see: Don't Forget to Review Your Life Insurance.)
This article represents the opinion of Mitlin Financial Inc. It should not be construed as providing investment, legal and/or tax advice.