Have you ever experienced a flat tyre while driving? You can feel the car lose balance on the side of the flat tyre.
To fix it, you would replace the flat with a spare. And doing this, brings back the balance of car.
Well just how you would rebalance your car by replacing the flat tyre, you do exactly the same with your investment portfolio.
Rebalancing in investment terms is the process of re-aligning the weightings of assets in your portfolio.
This involves periodically buying or selling assets to maintain your original or desired level of asset allocation or risk.
For example, a common investment strategy is the 60-40 rule. This means, 60% of the portfolio is invested in stocks and 40% invested in bonds.
If stocks outperform and push the weighting to 80%, an investor would then sell 20% of their stocks and invest this into bonds to regain the 60-40 balance.
Now there's more than one way to rebalance your portfolio…
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Three strategies you can use to rebalance starting today
1) Create a fixed time-table to rebalance your portfolio
This is when you schedule time i.e. yearly, quarterly or even monthly to rebalance your portfolio. This helps to maintain the discipline of routinely looking at how the shape of a portfolio has changed.
The upside: Frequent rebalancing helps you stick more closely to your actual asset allocation. And this won't affect performance or volatility in a material way.
The downside: The costs of frequent rebalancing in terms of taxes, commissions, and time and labour can affect your overall returns quite dramatically.
2) Rebalance your portfolio the risk-adverse way
Let's say you only want to allocate 10% of bonds to your portfolio. And, you never want your bonds investments to exceed the 10% - this is where threshold rebalancing comes into play.
With this second strategy, you rebalance your portfolio when the weight of an asset (bonds in this instance) exceeds your specific target.
This is a more proactive and less risky approach, because it acts quickly to stop a portfolio becoming too heavily weighted in certain assets.
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3) Time-and-threshold – the best way to rebalance and reduce costs
If you take into account both costs and returns, a great solution is time-and-threshold rebalancing. In other words, review your portfolio periodically and only rebalance the stocks that have moved beyond your pre-set thresholds.
The rule of thumb for investors is once a year with a 5% threshold.
But you don't have to follow this exact rule. Just ensure you can keep costs down by rebalancing at times when you add more funds.
For example, you can reinvest your dividends into whichever asset needs topping up. This is a good way to get your portfolio's weighting back within your threshold without paying extra costs. While allowing room for individual positions to grow before you clip their wings.
The bottom line is at least yearly rebalancing is generally a good idea, provided you do it for the right reasons and only when your portfolio really needs it.
See you next week.
Josh Benton, Real Wealth