To restore to the correct balance.
By Tim Flick, CFP®
In short: The primary goal of a rebalancing strategy is to minimize risk relative to a target asset allocation. A portfolio’s asset allocation is the major determinant of a portfolio’s risk-and-return characteristics. Yet, over time, asset classes produce different returns, so the portfolio’s asset allocation changes. Therefore, to recapture the portfolio’s original risk-and-return characteristics, the portfolio should be rebalanced.
What is Rebalancing? Rebalancing is the process of realigning the weightings of your portfolio assets. Rebalancing involves periodically buying or selling assets in a portfolio to maintain an original desired level of asset allocation.
For example: say our original target asset allocation for your account was 50% stocks and 50% bonds. If the stocks performed well during a period, it could have increased the stock weighting of the portfolio to 70%. The investor could then decide to sell some stock and buy bonds in order to get the portfolio back to the original target allocation of 50/50.
While the term “rebalancing” has connotations regarding an even distribution of assets, a 50/50 split is not required. Instead, rebalancing a portfolio involves the reallocation of assets to a defined makeup by the investor. This can be a target allocation of 50/50, 70/30 or 40/60…
Often these rebalancing steps are taken to ensure the amount of risk involved is at the investor’s desired level. As stock performance can vary more dramatically than bonds, the percentage of assets associated with stocks will change with market conditions. Along with the performance variable, investors may adjust the overall risk within their portfolios to meet changing financial needs.
Rebalancing for Diversity? Depending on market performance, investors may find a large number of current assets held within one area. For example, should the value of asset class X increase by 25% while asset class Y only gained 5%, a large amount of the portfolio is tied to asset class X. Should asset class X experience a sudden downturn, the portfolio will suffer a higher loss by association. Rebalancing lets the investor redirect some of the funds currently held in asset class X to another investment, be that more of asset class Y or purchasing a new asset class entirely. By having funds spread out across multiple asset classes, downturn in one will be partially offset by activities of the others, which can provide a level of portfolio stability.
In conclusion: With the choice of inadvertently taking on more risk over time or rebalancing back to our intended risk model, we choose to rebalance.