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  • Doug Oosterhart, CFP®

What is Portfolio Rebalancing?

Rather than blindly picking investments, when one first establishes an investment portfolio (or portfolios), one of the first steps is to choose a certain asset allocation. What is an "asset allocation" you might ask? Well, generally speaking, it's an output that is based on a few factors that are specific to each investor. Factors like: time horizon, risk tolerance, volatility tolerance, the "sleep well at night" factor, and how much return one might *need* to have a comfortable level of success in their plan (more on that factor in a later post).

One's asset allocation can have certain rules as well. For example: for an individual stock picker, they could have a rule that in their portfolio, no single stock will ever make up more than 5% of the total balance. Another example could be that for a globally diversified portfolio, an investor may always want to have a 1:1 ratio between foreign and domestic companies. Neither of these are hard and fast recommendations, they are just examples.

Once an investor has determined how they want to invest, should they just set it and forget it? Answer: no. This isn't a Showtime Rotisserie solution created by Ronco. It's your nest egg.

Even if you choose to invest in index funds, it's important to rebalance the portfolio over time - especially in times of big volatility swings in the market.

For example: to keep things simple, let's say that you choose to invest 60% of your portfolio into stocks and 40% of your portfolio into bonds. Generally speaking, over time, stocks have outperformed bonds. Therefore, if the stock allocation in your portfolio earns a higher return than the bond portion, the portfolio will be "out of balance." See the image below for a visual.

So, what should you do? Well, if your investment goals haven't changed, it's important to rebalance the portfolio back to the initial allocation that is in line with those goals. Simply put, rebalancing is the strategy of adjusting your asset allocation to make sure it remains consistent with your investment goals. The goal is to make sure you are always buying low and selling high.

Why is this important and/or why should you care?

The risks of not rebalancing your portfolio can be huge. If you're supposed to have a 60/40 portfolio (based on your goals), and the stock market explodes, you could be sitting at 80/20. Chances are, at that time, you would be closer to retirement AND your portfolio would be more aggressive than you desire.

If you then enter retirement more aggressively than you should be, and the market goes down 40%, you could be left will large losses at the worst time.

The biggest risk of not rebalancing your portfolio is the possibility that you'll find yourself with too much money in one type of investment at the absolute worst time.

Periodic rebalancing is a way to maintain your desired allocation in a portfolio. Failing to do so can expose you to greater risk, whether the stock market is rising or falling.

How should an investor rebalance their portfolio? How often should they do it?

There are a couple of different ways that investors can rebalance their portfolios.

1. Choose a time

Some investors choose to rebalance monthly, quarterly, annually, etc. One of the pros of this type of rebalancing is that it's relatively easy to track. Simply pick a date and do it. However, the cons are that one might let their emotions get involved when the time to rebalance comes. They may feel that it's not the "right time" to buy stocks or to sell stocks. This could cause some inefficiencies in their portfolio.

2. Use mathematics

Taking as much emotion out of it as possible, in general, the best solution for long-term investing success. I'm a fan of using thresholds or "rebalance bands" for clients. For example, let's say that an investor is targeting a 60/40 portfolio using 1 index fund for stocks and 1 index fund for bonds (to keep it simple). With the help of software, I'm able to set a threshold that would say something like, "if the stock fund goes up or down by 10%, send a notification to rebalance the portfolio."

3. Hybrid approach

Taking a blend of options 1 and 2, an investor could say, "I'm planning to rebalance the portfolio annually, but will do so more frequently if the imbalance were to exceed a certain threshold."

At the end of the day, the most important thing is that you are invested based on your goals and not anyone else's. That's why it's your investment portfolio. Rebalancing will help you keep the amount of risk you take right where you want it and help you sleep better at night.

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