Rebalancing investment portfolio is a very effective way of managing investment risk for passive investors. After you had determined the right asset allocation, rebalancing it at a certain time-based schedule is crucial to ensure the that you practice the simplest strategy of investment — buy low and sell high. As mentioned in my previous post, this is one of the three secrets of investing in unit trust.

Now the question is: How often should we rebalance our investment portfolio?


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Where you place the money in your hand?

Photo Credit: Steve Woods

There is a great article posted at My Money Blog summarizing that there is no concrete right answer on the best frequency of portfolio rebalancing. The author concludes that:

“….the most important thing is to just make sure you set up some way to rebalance that does not involve any emotions or market timing. Don’t worry about the details, but don’t let your portfolio run off on its own either. ‘Better To Have Rebalanced Regularly Than Not At All.”

It is definitely yielding better return with lower risk for those who rebalance regularly compared to those who don’t. It is just common sense. You never lock the gain if you never sell your investment vehicles when it is high.


Image: Lowered Risk and Increased Returns if Rebalancing Portfolio

Rebalancing is not Reallocation

But first and foremost, don’t confuse between rebalancing with reallocation. As stated by Dryan Olson,

  • Rebalancing is adjusting your portfolio through time to keep it in sync with your risk level. For example, say you’re a moderately aggressive investor with an asset allocation of 80% stocks, 15% bonds and 5% cash. If the outperformance of your stock investments pushed that mix to 90% stocks and 5% bonds, you might sell some stocks and buy some bonds to bring those percentages back in line.
  • Reallocation is shifting to a new asset allocation that reflects an entirely different risk level. For example, an investor in her 30s may prefer an aggressive asset allocation with 95% stocks. But by the time she retires, she may switch to a moderately conservative approach with only 40% stocks.

Reallocation might be done at later stage when you are approaching your retirement age, or when you need the liquid cash from your investment. But rebalancing should be done regularly. It might be half-yearly, yearly, or every two years. It also can be event driven. You can also set a return target to trigger your balancing act.

Perfect Time to Rebalance

There is no perfect time, because timing is never right. It is impossible to sell at the highest price, neither to buy at the lowest price. Rebalancing regularly will reap the return in between the highest and the lowest.

Fixed schedule

Technically, you can rebalance whenever you like. But “whenever” is almost an unknown date. It might take you forever. So just stick to something with much simplicity — rebalancing yearly. You can do it monthly if you like, but there is just too much work for you and also for the financial planners. Moreover the effect of doing it more frequent than once a year is not significant enough to justify the trouble you have to go through. Fix an appointment with your investment adviser and agree on a date for annual rebalancing.

Event driven

This is more tactical in the sense that you need to follow the market. For instance, when there is certain major announcement from the government that boost up your stock portion in certain industry, this will make your portfolio unbalance. You might want to sell some stocks holding in that particular industry and buy the other diversified funds. Another example is when the interest rate is adjusted which will affect the bond fund performance. Your portfolio might be out of balance again and it is appropriate for you to rebalance it back to the original allocation.

Portfolio change driven

This is also known as target rebalancing. You shall rebalance portfolio when a portion of your portfolio hit the return target. For example, your original stock portion is 50%. After a year it grows up to 75%, giving you a 50% return, you shall then sell off the excess return and rebalance it back to 50% of your entire portfolio. Theoretically, this style of rebalancing makes perfect sense in that it doesn’t allow your portfolio ever to drift too far from your original allocations. The suggested target is 15% change on the asset classes. Again, this is troublesome because you will need to monitor very closely.

Summary

  • review portfolio for rebalancing at least once a year
  • rebalancing help you to follow through the investing principle of buy low, sell high which will protect your profits and lower the volatility
  • use the simple way that can trigger you to rebalance, which most people recommended — calender rebalancing at a fixed schedule.

Rebalancing should be a standard operating procedure for every investor since it is relatively easy to restore a portfolio to its original allocation mix. Regardless of your objectives and risk tolerance, the major benefit of periodic risk management is significant reduction in portfolio volatility.

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KCLau
KCLau

Personal finance author and trainer

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