Set it and Forget it? The Importance of Rebalancing

In a recent post, we discussed the topic of Asset Allocation. Admittedly, the process of identifying a suitable Asset Allocation for your unique circumstances sounds as appealing as a trip to the dentist. However, the mix of stocks, bonds, cash and other investments is among the most important investing decisions you will make.

After determining a suitable investment mix, many investors think that they can sit back and enjoy the ride. To the contrary – putting your portfolio on auto pilot is never a good idea. Basic maintenance of your portfolio should include periodic “rebalancing” among the various asset classes. A rebalance is like a course correction for a sailboat pulled adrift by changing tides – re-aligning your portfolio in consideration of market movement and economic events. Let’s look at an example.

Imagine you sat down with your advisor five years ago. You discussed your goals, time horizon, risk tolerance and other unique preferences. You both agreed that an asset allocation of 50% stocks and 50% bonds would meet your needs and honor your risk tolerance. Fortunately for you, the stock market has done extremely well over the past five years and your portfolio reflects significant growth. At the same time, the bonds in your portfolio haven’t done quite as well. As a result of this lopsided performance, your asset allocation is now closer to 64% stocks and 36% bonds.

From a risk perspective, the current portfolio with 64% in stocks is much more vulnerable to a drop in the stock market than a portfolio with 50% stocks.  As a result, the current asset allocation may not be suitable given your risk tolerance and time horizon. In this example, a “rebalance” would entail selling stocks and buying bonds in order to realign the portfolio with your long-term target asset allocation. Importantly, this significant change in allocation and risk exposure was entirely passive – requiring no aggressive decisions on your part. As such, these changes can occur slowly and are easy to miss. Periodically rebalancing the portfolio keeps your asset allocation aligned with the intended target; it also helps to impose discipline to your investment process.

In an ideal world, it would always be simple: lock in profits by selling the winners, re-allocate funds to the underweight asset classes. But there are other considerations that would influence when and how you should rebalance a portfolio: taxes, transaction costs, and changes in investment objectives, to name a few. Nevertheless, rebalancing over time is an important part of portfolio maintenance that will enhance discipline and keep you on course.

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