U.S. Markets closed

Rebalancing: What it is and why it may be important to your portfolio

Rebalancing: What it is and why it may be important to your portfolio

Chances are, if you ever sat with a financial advisor you likely came away with at least two things. A sick feeling that you probably need to save a lot more in order to reach your goals, and a snazzy pie chart that shows how much exposure you should have in various types of investments to best achieve that monetary target.

For this installment of Investing 101, we take a closer look at the pie chart and a key element of this investing style: Rebalancing! It’s often overlooked and when it is, can seriously hurt your returns. 

Whether you’re a new investor just starting out or a well-heeled veteran of the markets, every planner and advisor will tell you that you need to have a personalized plan that reflects your particular investment goals and tolerance for risk. Once this blueprint has been set the normal course of executing it consists of putting specific portions of your money into various asset classes like: 60% of your portfolio in stocks,  30% in bonds, and 10% in cash.

It’s an easy and proven way to diversify your investments and increase your chances of success. Depending your personal needs financial consultants will typically recommend that investors “rebalance” their holdings at least once a year, and in some cases even more often, to ensure that the objectives of your original recipe are being followed.

Here’s an example. If Jane Dough had put $10,000 into the markets at the start of this year via a portfolio that was split 60/30/10 percent between stocks, bonds and cash, her holdings would be dramatically different today. While her cash allocation would have done nothing, her stock and bond investments would have moved a lot. 

Using the iShares 20 Year Treasury ETF (TLT) as an example Jane’s $3,000/30% original commitment to bonds would be down about 15% to $2,550 today. At the same time her original $6,000/60% allocation to stocks, had she gone with the S&P 500 SPDR (SPY), would be up 27% to to $7,600.

Add that all up and her portfolio would have grown to $11,150 of which 68% would be in stocks, 23% in bonds just  9% in cash as of December 1.

Had Jane done nothing to rebalance her stock, bond, and cash holdings over the past three years, her present mix would have morphed to 76 /17 / 6 percent respectively today.

So how should Jane adjust her portfolio? 

It may seem counterintuitive but the best way to decrease risk in your portfolio is to trim your winners and feed your losers. The aim in the example above would be for Jane to take money from her stocks and re-invest it in bonds and cash in order to get back to that 60 / 30 / 10 spread she started with.

Because this rebalancing seems so contradictory, some argue the best thing to do is avoid rebalancing altogether. On his blog, legendary investor Jack Bogle of Vanguard has this to say of the practice:

Rebalancing is a personal choice, not a choice that statistics can validate. There’s certainly nothing the matter with doing it (although I don’t do it myself), but also no reason to slavishly worry about small changes in the equity ratio.

When it comes to investing successfully, it’s all about sticking to your goals and managing your risk. Periodic rebalancing of the different asset classes in your portfolio can have a profound impact - it’s just about finding what is right for you.