In the world of investing, rebalancing a portfolio is a crucial practice for long-term investors to maintain the desired risk-return balance over time. As the market changes, the percentage of assets in your portfolio changes, which can affect your original investment. This article explores the importance of balance and offers practical tips for implementing this important investing concept.
This is why rebalancing is important
At the same time, business moves can cause your portfolio to deviate from its intended purpose. For example, if stocks are outperforming bonds, your portfolio may be heavily weighted toward stocks, exposing you to more risk than you initially thought. Rebalancing provides stability in the face of changing market conditions, keeping your portfolio consistent with your risk tolerance and investment goals.
Setting the rebalancing time
There are two methods of rebalancing: calendar and startup.
- Calendar-based rebalancing: This involves reviewing and adjusting your data at regular intervals (such as annually or semi-annually). It’s simple and straightforward, and helps maintain discipline without the need for frequent operations.
- Threshold-based rebalancing: This method results in rebalancing when assets differ from the target by a predetermined percentage. It can respond more quickly to market changes but requires more frequent monitoring.
There are advantages to both methods, and the choice depends on your investment and the time you can dedicate to data management. As the end of the year approaches, it’s a good time for investors to think about balancing, regardless of which path is chosen.
Steps to Rebalance Your Data
- Assess current allocations: Begin by reviewing your current portfolio allocations. Calculate the percentage of each asset class relative to your total portfolio value. Also do this for your regional, sectoral and thematic exposures.
- Compare to target allocations: Determine how these current allocations compare to your target allocations. Identify any asset classes, regional, sectoral or thematic exposures that are over- or under-weighted.
- Execute trades: Adjust your holdings by buying or selling assets to bring your portfolio back in line with your target allocations. Be mindful of transaction costs and market liquidity when executing trades.
- Document changes: Keep a record of the changes made and the rationale behind them. This documentation can be valuable for future reference and maintaining a disciplined approach.
Case Study: Rebalancing a 60/40 Stock and Bond Portfolio
Initial setup
On January 1, 2024, an investor starts with a $100,000 portfolio: 60% allocated to SPY (a mutual fund ETF that tracks the S&P 500 Index), 40% allocated to TLT (a long-term U.S. Treasury bond ETF for bonds).
- SPY: $60,000.
- TLT: $40,000.
Year-to-date performance
As of 27 November 2024, SPY is up 27% YTD, and TLT is down 3%.
- SPY new value: $60,000 * 1.27 = $76,200.
- TLT new value: $40,000 * 0.97 = $38,800.
- Total portfolio value: $76,200 + $38,800 = $115,000.
Current allocation
- SPY: ($76,200 / $115,000) * 100 = 66.26%.
- TLT: ($38,800 / $115,000) * 100 = 33.74%.
Rebalancing steps
To return to a 60/40 allocation:
- Target SPY value: 60% of $115,000 = $69,000.
- Target TLT value: 40% of $115,000 = $46,000.
Potential actions
- Sell $7,200 of SPY ($76,200 – $69,000).
- Buy $7,200 of TLT ($46,000 – $38,800).
By executing these trades, the portfolio realigns to its intended risk profile, demonstrating the importance of rebalancing to maintain investment goals.
The common rebalancing trap
Investors may fall into several traps when rebalancing, such as:
- Decision Making: Letting emotions drive back and forth decisions can lead to bad timing and bad business.
- Ignoring balance: Ignoring the need for balance, especially during periods of market volatility, can lead to unsustainable risks.
- Recapitalization: Excessive recapitalization can reduce overall returns by increasing transaction costs and potentially tax consequences.
- Ignoring costs: Ignoring transaction costs and making competitive demands can affect the outcome of the equation.
- Inconsistent strategies: Failure to adhere to a consistent timeframe or threshold can lead to inconsistent data management.
- Focus only on assets: Ignoring the need for balance across assets (such as sectors or regions) can lead to imbalances.
- Timing the Market: Trying to time the market when returns are equal can expose a stock to additional risk and uncertainty.
