Portfolio rebalancing is a process of adjusting your investment holdings to match your desired level of risk and return. It involves selling some assets that have grown in value and buying more of those that have declined, to restore your original asset allocation.
Why is portfolio rebalancing important? Because over time, your portfolio may drift away from your target allocation due to market fluctuations. This can expose you to more or less risk than you intended and affect your long-term performance.
For example, suppose you started with a portfolio of 60% stocks and 40% bonds, based on your risk tolerance and financial goals. After a year of strong stock market returns, your portfolio may have shifted to 70% stocks and 30% bonds. This means you are taking more risk than you planned, and you may be vulnerable to a market downturn. To rebalance your portfolio, you would sell some of your stocks and buy more bonds, until you reach your 60/40 allocation again.
There are different ways to rebalance your portfolio, depending on how often and how much you want to adjust your holdings. Here are some common portfolio rebalancing strategies:
- Calendar rebalancing: This strategy involves rebalancing your portfolio at regular intervals, such as monthly, quarterly, or annually. The advantage of this approach is that it is simple and consistent. The disadvantage is that it may not account for market conditions or significant changes in your portfolio value.
- Percentage-of-portfolio rebalancing: This strategy involves rebalancing your portfolio whenever an asset class deviates from its target allocation by a certain percentage, such as 5% or 10%. The advantage of this approach is that it is more responsive to market movements and keeps your portfolio closer to your target allocation. The disadvantage is that it may require more frequent trading and incur higher costs and taxes.
- Constant-proportion portfolio insurance: This strategy involves rebalancing your portfolio to maintain a constant cushion of low-risk assets, such as cash or bonds, to protect against losses. The advantage of this approach is that it reduces downside risk and preserves capital. The disadvantage is that it may limit upside potential and miss out on market rallies.
Portfolio rebalancing is an essential part of managing your investments. It helps you stay on track with your financial plan and avoid taking unnecessary risks. However, rebalancing also involves trade-offs, such as costs, taxes, and timing. Therefore, it is important to choose a rebalancing strategy that suits your goals, preferences, and circumstances.
To find out more about portfolio rebalancing and its impact on performance or which is the best rebalancing strategy, please check out our articles "Importance of Asset Portfolio Rebalancing and How It Impacts Performance" on our website Smart Money Diary. A very handy tool for portfolio rebalancing you can download from our website here.
Disclaimer: The scenarios or investment products presented above should not be construed as investment advice. All investments involve some level of risk, and past performance is never a guarantee of future returns. As always, do your own research in order to validate and better understand the underlying risks.
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