What is portfolio rebalancing?

Q: You often hear that you should rebalance your portfolio. I’m 56 and recently inherited a substantial sum of money, but I’ve never invested before. This has to pay for my retirement! Will you please explain to me what rebalancing is, why it’s important, and how often a person like me should do it? -Janet M

A: Great question! Let’s break it down.

Let’s say that you work with an advisor to allocate your assets. (Asset allocation is how you divide up your investments among stocks, bonds and even cash.)

So, your advisor should work with you to determine (among other things) precisely how long it’s going to be before you retire and need the money, how much investment risk you want to take, how liquid you want your investments to be, and so on.

You’re nearing retirement, and you’ve inherited money, and so while I would likely advise you to go even more conservative than this, just for the sake of example, let’s say you invest: ^[1]

• 5% in very high-risk Asset Class A
• 30% in moderate-risk Asset Class B
• 35% in modest-risk Asset Class C
• 30% in low-risk Asset Class D

Let’s pretend your advisor is decidedly hands-off, she never calls you, and she doesn’t have your best interests at heart. She also doesn’t have the sophistication or the infrastructure in place to do automatic rebalancing (I’ll cover this is a moment). Let’s also assume that after one year none of your assets has declined. (They either stayed the same or went up in value.)

So, after a year, the markets have acted the way they usually do (unpredictably), and higher-risk, higher-volatility Asset Classes A and B have performed exceptionally well.

Based on the terrific growth of A & B, and the nominal growth (or static state) of C & D, your new allocation is:

• 13% in very high-risk Asset Class A
• 35% in moderate-risk Asset Class B
• 27% in modest-risk Asset Class C
• 25% in low-risk Asset Class D

Whereas one-year ago you had 35% of your portfolio in either high or moderately-risky investments, you now have 48% of your money in those asset classes. Based on your profile, there’s too much risk and not enough conservative investments from C & D.

(Investors often see short-term gains like those above, and think: “A and B are going up, up, up! Let’s get more of those right away!”)

Big mistake.

Remember, all investments carry some risk. But you’re nearing retirement, so a high level of investment risk is not your friend. Consider this: You initially allocated just 5% of your money in high-risk investments, but you now have 13%; an almost 3-fold increase.

All other things being equal (for instance, no investment sector collapses, no automatic rebalancing, and not accounting for fees for trades, etc.), your time horizon and risk tolerances should prompt your advisor to encourage you to rebalance.

So, in the simplest terms, rebalancing is the process of realigning the weightings of a portfolio of assets. It occurs when you and your advisor buy or sell portions of the various asset classes you own to get your allocations back in line with your specific investment preferences and risk tolerances.

Why is rebalancing important?

Rebalancing is important because it keeps your risk, relative to your ideal target asset allocation, in check.

Think of rebalancing (especially in this instance) as buying low and selling high.

Now, if the above example were real, and you were, say, 26-years old, and had a comparable asset allocation mindset, being that you’d still be in the asset accumulation stage of life (and have lots of time to recover), I wouldn’t be as concerned if you were determined to “let it ride.”

But being that you’re 56, and close to retirement, and that this appears to be all the money you have, I certainly wouldn’t be comfortable encouraging you to stay so far out of balance.

There are a lot of variables.

In the end, you have a particular risk tolerance profile with specific goals in mind, and so it’s inadvisable to let what the markets are doing today distract you from that.

How often should you rebalance?

The short answer is, as often as necessary.

We automatically rebalance portfolios. We place clients in portfolios based on the information we gather from them during meetings, including a “Risk Tolerance Questionnaire,” (RTQ), which helps us identify which strategy best aligns with their goals and objectives.

While some advisors rarely rebalance a portfolio, we constantly monitor ours. Changes in the market can quickly take a portfolio far outside its target range. Automatic rebalancing means that if the variance in a position exceeds the tolerance we’ve set for the portfolio, the trader is alerted and a rebalancing commences.

So, how often should you rebalance? While there may be other considerations, you should rebalance as often as is necessary to stay in alignment with your tolerances, goals and objectives.

Conclusion

While this is a simplified summary of rebalancing, I hope it gives you an idea of the complexities of investing and asset allocation. If nothing else, let me encourage you to work with a fiduciary advisor who will only make recommendations that are in your best interests.

For more information, watch our retirement planning tutorial.

Diversification, rebalancing, and asset allocation do not ensure a profit or guarantee against loss.

[1] This is a simplified example for illustrative purposes only.