What Is Rebalancing And Why Is It Important?Submitted by Castlebar Asset Management on November 12th, 2015
Bringing balance to our lives is something all of us strive for daily. It might be balancing your work and family life or your professional goals and your personal goals. We struggle to figure out how to best meet the demands that we are looking to accomplish. Our investments have an alignment issue at times as well. Fortunately it is easier to rebalance our investments than it is our lives when they are out of alignment.
What is Rebalancing?
Rebalancing your investments is performing some routine maintenance on your investments. Over time they may get out of alignment. It is often an overlooked task to make sure your investment portfolios continue to match your target investment allocation.
Why Should I Rebalance?
You have created a plan and what good is a plan if you are not going to stick to it. You spent the time trying to figure out what the right investment mix is for you based on your goals, time to meet those goals and your personal risk tolerance. Ignoring your target investment allocation once you set it up is silly. There is overwhelming evidence that shows rebalancing your investments periodically leads to better outcomes than just letting them drift with the market.
An example: Using a simple example of owning 60% stocks and 40% bonds in your account. If stocks rise 10% over a 12 month period and bonds increase only 2.5%, your portfolio is out of aligned with stocks now being about 62% and bonds being about 38%. To bring your portfolio back in line with your target investment allocation you should sell about 2% of your stocks and buy 2% more in bonds.
This activity will help you manage your portfolios risk as well as force you to sell high and buy low. Many investors do the opposite!
How should you rebalance?
What should cause you to rebalance your investments? There are two simple ways to base your decisions on when to rebalance. You can use a physical calendar or when your portfolio is out of alignment by a certain percent.
Using the calendar to guide your rebalancing activity is the most straight forward. You select a date once a year and rebalance your portfolio to your target investment allocation. This will bring discipline to your rebalancing activities. I recommend you select a date like your birthday, a child’s birthday or your anniversary to rebalance your investments. It should be roughly the same date every year so you have consistency in your approach. Some years you won’t have to make any changes while others will require more.
The second way to base your decision to rebalance is to set a percentage target. Using our 60% / 40% example, you would base your decision on a percentage threshold of 5%. You can pick any number but I think it should be great than 2.5%. Once your portfolio had a weighting of 65% stocks and 35% bonds you would then rebalance back to the correct allocation. This approach requires a little more monitoring and can lead to a little more tinkering. If you want to monitor your investments closer this is a better approach.
When you rebalance you should ignore market sentiment or your own opinion on the markets. This will put you in the position of market timing or worse taking no action because you are waiting for something to happen which you have no control over.
It will only take a few minutes a year but will keep you on track to meet your financial goals.
Disclaimer: The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. To determine which investment(s) may be appropriate for you, consult your financial advisor prior to investing. All performance referenced is historical and is no guarantee of future results.