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Rebalance Your Portfolio to Stay on Track

2017-02-22 19:21 | Network |

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.

 Rebalance Your Portfolio to Stay on Track
(Tip:click the picture to see the big picture.)

 

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.

 Rebalance Your Portfolio to Stay on Track
(Tip:click the picture to see the big picture.)

 

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.

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.

 Rebalance Your Portfolio to Stay on Track
(Tip:click the picture to see the big picture.)

 

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.

 Rebalance Your Portfolio to Stay on Track
(Tip:click the picture to see the big picture.)

 

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.

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:

(Editor:FinAll)
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