How often should you rebalance your investment portfolio?

Investing for the long-term requires a well-diversified portfolio that can withstand various market fluctuations. However, diversification alone is not enough. As the market changes, assets in the portfolio may become overvalued or undervalued, and therefore, it is important to periodically rebalance the portfolio. So, how often should you rebalance your investment portfolio?

What is Rebalancing?

Before diving into the frequency of rebalancing, let’s first define what it is. Rebalancing refers to the process of adjusting the weightings of assets in an investment portfolio. It involves selling assets that have become overweight and using the proceeds to purchase assets that have become underweight. The main objective of rebalancing is to ensure that the portfolio stays in line with the investor’s target asset allocation.

For instance, suppose an investor has a target allocation of 50% stocks and 50% bonds to achieve a balance between growth and income. If the value of the stock holdings increases over time, the portfolio may become overweight in stocks, say 60% stocks and 40% bonds. Rebalancing would involve selling some of the stocks and using the proceeds to purchase bonds to bring the portfolio back to the target allocation of 50/50.

The Benefits of Rebalancing

Rebalancing is not just about maintaining a particular asset allocation. It has several benefits:

• Reducing Risk: A well-diversified portfolio is less exposed to risk than a portfolio consisting of only a few assets. However, even a diversified portfolio can be exposed to risk if one or more assets become overvalued. Rebalancing helps to reduce this risk by ensuring that no single asset class dominates the portfolio.
• Capturing Gains: Rebalancing allows investors to capture gains by selling assets that have appreciated and locking in profits.
• Staying Disciplined: Rebalancing forces investors to adhere to their pre-determined investment strategy and avoid making emotional decisions based on short-term market movements.

How Often Should You Rebalance?

The frequency of rebalancing depends on several factors, including the size of the portfolio, the volatility of the assets, and the investor’s risk tolerance. Below are three main approaches to rebalancing:

1. Calendar-Based Rebalancing: Some investors choose to rebalance their portfolio on a set schedule, such as quarterly or annually. While it is simple and easy to implement, it may not be the most effective as it does not take into account market fluctuations and may result in unnecessary trading costs.
2. Percentage-Based Rebalancing: This approach involves setting a threshold, such as 5%, and rebalancing the portfolio only when an asset class deviates from its target allocation by the specified percentage. For instance, if an investor’s target allocation for stocks is 30%, and the value of the stock holdings increases by 5% or more, the portfolio would be rebalanced. It is more flexible than calendar-based rebalancing and can help to reduce trading costs.
3. Threshold-Based Rebalancing: This approach is similar to percentage-based rebalancing, but instead of using a fixed percentage, investors use a range or band. For example, an investor may set a 5% band for a target allocation of 30% for stocks. If the stock holdings deviate from this range, say to 25% or 35%, the portfolio would be rebalanced. It is the most flexible and takes into account market fluctuations.

Deciding which approach is best for you depends on your individual circumstances and goals. For instance, young investors with a high risk tolerance may prefer a less frequent approach, while retirees may prefer a more frequent one.

Factors to Consider Before Rebalancing

Before deciding how often to rebalance your portfolio, consider the following factors:

1. Risk Tolerance: Investors with a high risk tolerance may choose to rebalance their portfolio less frequently, as they can tolerate more market volatility. Conservative investors may prefer a more frequent approach to minimize risk.
2. Market Volatility: In volatile markets, assets can fluctuate rapidly, and hence, portfolio rebalancing may be required more frequently to maintain balance.
3. Trading Costs: Frequent rebalancing can result in higher trading costs, which can eat into returns. Therefore, investors should consider the cost of commissions, brokerage fees, and taxes when choosing a rebalancing strategy.
4. Tax Implications: Rebalancing can trigger capital gains taxes, which can reduce returns. Investors may want to consider the tax implications of their rebalancing strategy and consult with a tax advisor.
5. Portfolio Size: Smaller portfolios may require more frequent rebalancing to maintain target allocations, while larger portfolios may have more flexibility.

Conclusion

Rebalancing is a crucial part of portfolio management that helps investors maintain a well-diversified portfolio and reduce risk. The frequency of rebalancing varies depending on the investor’s individual circumstances and goals. While there is no one-size-fits-all answer, investors should consider their options and determine which approach works best for them.

Given the benefits of rebalancing, it is essential for investors to incorporate this practice as part of their investment strategy to ensure that their portfolios remain in check and help them achieve their long-term financial goals.