Rebalancing Basics
What is rebalancing?
Rebalancing your portfolio is the act of actively buying and/or selling investments in your portfolio to align your portfolio’s allocation to your desired levels.
Here are some definitions and links to help unpack the statement above:
Portfolio: An investment portfolio is the total of all your investments. Portfolios commonly contain stocks, bonds, and mutual funds but may also include other investments such as real estate, minerals, digital assets, cash, and other assets.
Allocation: Allocation is the proportion of value of an investment to the value of the entire portfolio. For example, you own $75 of stocks and $25 of bonds in your portfolio. Your portfolio has an allocation of 75% stocks and 25% bonds. Learn more here.
Desired allocation: You desired allocation is the distribution of investments you want in your portfolio (not necessarily your current portfolio allocation). Learn more here.
Why is rebalancing important?
Rebalancing your portfolio accomplishes two important tasks.
1. Rebalancing aligns your portfolio with you risk tolerance and investment goals.
2. Rebalancing naturally results in “buying low and selling high.”
Aligning your portfolio with your risk tolerance and investment goals
Over time certain asset classes will outperform other asset classes. Rebalancing allows an investor to adjust the aggressiveness of their portfolio to match their goals. The act of rebalancing allows and investor to reduce risk when a more volatile asset experiences significant gains and can conversely increase aggressiveness when a volatile asset loses significant value.
In 2019, broad market US stock funds gained approximately 30% and broad market bond funds gained approximately 10%. Let’s assume that at the start of 2019, your portfolio was well balanced at your desired allocation, 50% stocks and 50% bonds for this example. However, after the steep stock market gains in 2019, your portfolio has significantly more value in stocks than bonds. Your portfolio at the end of 2019 would be 55% stocks and 45% bonds. This change in allocation may not align with your risk tolerance. Rebalancing brings your portfolio back in line with your risk tolerance.
“Buy Low and Sell High”
The act of rebalancing naturally results in selling assets that have experienced disproportionate gains and adding investments to assets that have performed more poorly.