Why Rebalancing Your Investment Portfolio is Crucial?
Investing can be intimidating as many options are available, making it overwhelming, particularly for new investors. Diversifying an investment portfolio across various investment types and sectors is crucial in reducing risks while increasing investment returns. However, after diversification has been achieved, portfolio rebalancing becomes necessary to maintain diversification. Portfolio rebalancing refers to the process of realigning an investment portfolio’s assets to match the target asset allocation. This article delves into the importance of portfolio rebalancing and how it can assist one in achieving their long-term investment goals.
What is Portfolio Rebalancing?
Portfolio rebalancing is the process of adjusting the allocation of assets in an investment portfolio to align with the desired asset allocation. Asset allocation, on the other hand, entails the percentage of a portfolio that is assigned to different investment types, such as commodities, cash, real estate, bonds, and stocks. If one aims to have an asset allocation of 60% stocks and 40% bonds and their portfolio has drifted to 70% stocks and 30% bonds, portfolio rebalancing becomes necessary. Therefore, the investor sells some stocks and procures an equivalent amount of bonds to achieve their original targeted allocation. In essence, portfolio rebalancing ensures that the portfolio’s risk and return remain consistent with the investment objectives.
Why is Rebalancing Important?
There are several reasons why rebalancing an investment portfolio is vital. Firstly, market conditions and investment performance can cause an investment portfolio’s asset allocation to drift from its original target allocation over time. Secondly, rebalancing can assist in regulating an investor’s investment portfolio risk exposure. Lastly, rebalancing helps an investor avoid the temptation of chasing investable assets once they have peaked.
How to Determine Asset Allocation?
Determining one’s asset allocation requires considering several factors, including the investment goals, time horizon, and risk tolerance. Firstly, one should define their investment goals to determine the appropriate investment strategy. Secondly, it’s essential to determine how much risk one is willing to take to achieve their investment goals. Risk-averse investors may adopt a more conservative investment strategy that focuses on income generation. Conversely, risk-seeking investors may prefer the aggressive investment strategy, emphasizing higher return potential and capital appreciation. Thirdly, one’s time horizon, which relates to how long they plan to invest in meeting their investment goals, should be assessed. Lastly, an investor should review their portfolio regularly to determine whether it reflects their targeted allocation.
When Should One Rebalance Their Portfolio?
Portfolio rebalancing should be ongoing and not a one-time event. It should be done regularly to ensure that the portfolio remains aligned with the investment goals, time horizon, and risk tolerance. Generally, rebalancing every six to twelve months or whenever the portfolio drifts over 5% from the target allocation is recommended.
How to Rebalance One’s Portfolio?
Portfolio rebalancing can be achieved via two main ways: the selling and buying method and incremental contribution. The selling and buying method entails selling overweighted assets and buying underweighted ones. Alternatively, the incremental contribution method involves adjusting one’s portfolio over time using incremental contributions.
Benefits of Portfolio Rebalancing
Portfolio rebalancing reduces investment risks, increasing the chances of achieving long-term investment goals, and makes investing more disciplined. Additionally, it can increase investment returns and offer tax benefits when performed within tax-advantaged accounts.
Conclusion
Rebalancing an investment portfolio is necessary to maintain diversification, reduce investment risks, and increase investment returns. The investor should strive to rebalance their portfolio regularly to ensure the investment goals remain within reach and minimize tax implications. It is essential to note that rebalancing should be done consistently and not as a one-time event.