Why rebalancing of investment portfolio is need of the hour; how to do it (2024)

FAQs

Why rebalancing of investment portfolio is need of the hour; how to do it? ›

Portfolio rebalancing adjusts the weights of different assets in your portfolio to match your investment goals and risk tolerance. It helps you benefit from market trends by selling the assets that have risen in value and buying more of those that have fallen in value.

It states that rebalancing between assets should occur only if an asset or category has drifted from its original target by an absolute percentage of 5% or a relative of 25% whichever is less.

Vanguard's research paper on this subject suggests that, for most investors, rebalancing on an annual basis is adequate. “Whether it's 60/40 or another asset allocation, rebalancing will help make sure your portfolio is consistent with your risk tolerance,” Schlanger said.

The various factors that the investor needs to keep in mind while rebalancing his portfolio include asset allocation targets, market performance, time horizon, risk tolerance, tax implications, cash flows, market conditions, review period and investment goals.

To rebalance a portfolio, an individual buys or sells assets to reach their desired portfolio composition. As the values of assets change, inevitably the original asset mix will change due to the differing returns of the asset classes. This will change the risk profile of your portfolio.

Research from Vanguard shows there is no optimal rebalancing strategy. Whether a portfolio is rebalanced monthly, quarterly, or annually, portfolio returns are not markedly different.

If you do your rebalancing in a tax-deferred account, like a pre-tax 401(k) or even a tax-exempt account like a Roth IRA, you'd steer clear of any tax whatsoever. This is because these retirement accounts are subject to special rules that allow you to avoid taxation once money is in the account.

The bottom line

Our research shows that optimal rebalancing methods are neither too frequent, such as monthly or quarterly calendar-based methods, nor too infrequent, such as rebalancing only every two years. For many investors, implementing an annual rebalancing is optimal.

According to this rule, stocks can potentially return 10% annually, bonds 5%, and cash 3%. While these figures are not guarantees, they serve as a guideline for investors to forecast potential returns and adjust their portfolio accordingly.

What are the disadvantages of rebalancing a portfolio? ›

Many investors find January to be a good month to establish disciplined annual rebalancing since they will know their portfolio is allocated as intended at the start of every New Year.

Rebalancing is an important way to help minimize volatility in a portfolio and may improve long-term returns. Setting specific thresholds that trigger rebalancing can help eliminate emotion from the rebalancing process.

Selling assets to rebalance a portfolio will generate trading costs and perhaps also capital gains taxes.

Apply the 5/25 rule

When an asset class shifts from its original target by 5%, you should rebalance it. Let's imagine that your portfolio is originally 80% stocks. But then, the actual value shifts to 75% or 85% of your portfolio makeup. Since your investment makeup moved by 5%, you would rebalance your portfolio.

The major friction that investors face in rebalancing their portfolios is capital gains taxes, which are triggered by the sale of assets.

Rebalancing is the act of adjusting a portfolio's changed asset allocation to match an original allocation defined by an investor's risk and reward profile. There are several types of strategies for rebalancing, such as calendar, constant-mix, and portfolio-insurance.

Rebalancing will reduce the portfolio's volatility, but the cost of rebalancing will also reduce the portfolio's net returns. An optimal rebalancing strategy, therefore, requires a risk-return tradeoff.

Bottom Line. Rebalancing your portfolio is an important step towards reaching your financial goals. It reduces risk and ensures that your portfolio mix isn't out of balance. While some investors choose to rebalance manually, most choose automatic rebalancing for its simplicity and time-savings.