- When you start investing, you go in with a plan about how you want to allocate your portfolio, but as the market moves, your portfolio can move with it—leaving you with a different allocation of stocks and bonds than you wanted
- Rebalancing is a key part of keeping your portfolio on track, and avoiding it can lead to serious changes in your investment portfolio
We’ve talked a lot about how making decisions about your portfolio based on market movements, or fear, or trying to predict performance, can all result in less-than-optimal performance, and hurt your overall returns (not to mention stress you out).
But there are a few times where you’re going to want to buy and sell some parts of your portfolio, and one of them is rebalancing.
When you first invest in a portfolio, you’re choosing a mix of different investments based on the balance between risk and return that’s right for you. That’s all well and good when you buy them, but as those investments change in price, your portfolio’s ideal balance can get thrown off over time.
That’s when it’s time to rebalance by selling some investments, and buying more of others, to get back to your ideal mix.
Think of it like a car. You can have the best car in the world, on the flattest, straightest road, but if you start driving it and take your hands off the wheel, eventually things outside of the car are going to push it off course.
Rebalancing your investments is like keeping your hands on the wheel: It will help you stay on the course you originally wanted with your investments.
Choosing an Investment Portfolio
When you’re choosing a portfolio, you’re doing it based on calm, rational theory, because you’re not invested yet—so you don’t have any of the pesky emotions that can skew your decisions.
That’s why it’s important to rebalance, so you don’t let your emotions impact your plan.
Generally, the biggest choice you’ll make is your asset allocation, but this isn’t where you pick stocks. Instead, you’ll be picking what percentage of your portfolio you want in equities, what percentage you want in bonds, and what percentage—if any!—you want in alternative investments.
Rebalancing is what you do when your portfolio starts to drift away from that ideal mix you chose early on, and while it might seem like a small thing, avoiding it can have serious implications for your investments and your overall plan.
Why Should You Rebalance Your Portfolio?
Luckily, you don’t need to find out what happens when you don’t rebalance, because there’s been research done to show you.
Vanguard did a study on two portfolios that would be considered “moderate” risk, with 60% equities and 40% bonds.
As a refresher about diversification, equities tend to be higher risk with higher expected return, and bonds tend to be lower risk, with lower expected returns.
One of these portfolios was rebalanced every month, so it kept a steady mix of 60% equities and 40% bonds over time.
The other portfolio was never rebalanced, and if you’re wondering how far it could possibly get from the ideal balance of 60/40, the answer is “very far.” Eventually, the never-rebalanced portfolio was made up of 99% equities and 1% bonds.
That’s a significantly different—and significantly more risky—portfolio than the one you started out with.
While there are times and situations in which it makes sense to change your asset allocation, “I just never got around to rebalancing it” isn’t one of them.
Leaving your portfolio to its own devices over time isn’t a viable solution.
How Do You Rebalance Your Portfolio?
So what’s an investor supposed to do?
There are a few options available to you to rebalance your portfolio.
If you’re buying and selling investments on your own, choose a set time to look at your portfolio every year and rebalance back to your original plan.
You can go with monthly, quarterly, or annually, but there are tax implications and costs to rebalancing, so you’ll just need to pick a regular cadence that works for your situation.
When it’s time to rebalance, you’ll need to sell the investments that have grown to represent too much of your portfolio, and use the proceeds to buy the investments that need to be bumped up.
Here’s an example to bring it down to earth:
If you’re trying to maintain a 60/40 mix between equities and bonds, and your portfolio is now 70% equities and 30% bonds, you’ll need to sell 10% of your equities, and put that money into bonds.
If you’re using an automated portfolio like Twine, one of the perks is that all of the rebalancing is done for you.
Instead of worrying about keeping your portfolio on track, Twine’s technology does it for you, and may rebalance your portfolio based on daily reviews so you don’t have to.
Investing 101: Let’s do this
Investing doesn’t have to be something scary and intimidating, and it’s one of the most powerful ways you can hit your goals and build wealth over the long term.
Make a Plan:
- Should I Save or Invest?
- Understanding the Stock Market
- Long-Term Investing
- The Relationship Between Risk and Return
- Investing for Beginners
- The Benefits of Diversifying Your Investments
- Types of Asset Classes
- 5 Common Investing Mistakes