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May 18 2009| Filed Under Bonds, Economics, Personal Finance
So you've established an asset allocation strategy that is right for you, but
at the end of the year, you find that the weighting of each asset class in your
portfolio has changed! What happened? Over the course of the year, the market
value of each security within your portfolio earned a different return,
resulting in a weighting change. Portfolio rebalancing is like a tune-up for
your car: it allows individuals to keep their risk level in check and minimize
risk.
What Is Rebalancing?
Rebalancing is the process of buying and selling portions of your portfolio in
order to set the weight of each asset class back to its original state. In
addition, if an investor's investment strategy or tolerance for risk has
changed, he or she can use rebalancing to readjust the weightings of each
security or asset class in the portfolio to fulfill a newly devised asset
allocation.
Blown Out of Proportion
The asset mix originally created by an investor inevitably changes as a result
of differing returns among various securities and asset classes. As a result,
the percentage that you've allocated to different asset classes will change.
This change may increase or decrease the risk of your portfolio, so let's
compare a rebalanced portfolio to one in which changes were ignored, and then
we'll look at the potential consequences of neglected allocations in a
portfolio.
Let's run through a simple example. Bob has $100,000 to invest. He decides to
invest 50% in a bond fund, 10% in a Treasury fund and 40% in an equity fund.
At the end of the year, Bob finds that the equity portion of his portfolio has
dramatically outperformed the bond and Treasury portions. This has caused a
change in his allocation of assets, increasing the percentage that he has in
the equity fund while decreasing the amount invested in the Treasury and bond
funds.
More specifically, the above chart shows that Bob's $40,000 investment in the
equity fund has grown to $55,000, an increase of 37%! Conversely, the bond fund
suffered, realizing a loss of 5%, but the Treasury fund realized a modest
increase of 4%. The overall return on Bob's portfolio was 12.9%, but now there
is more weight on equities than on bonds. Bob might be willing to leave the
asset mix as is for the time being, but leaving it too long could result in an
overweighting in the equity fund, which is more risky than the bond and
Treasury fund. (Learn more about the relative risk of various investments in
Determining Risk And The Risk Pyramid.)
The Consequences Imbalance
A popular belief among many investors is that if an investment has performed
well over the last year, it should perform well over the next year.
Unfortunately, past performance is not always an indication of future
performance - this is a fact many mutual funds disclose. Many investors,
however, remain heavily invested in last year's "winning" fund and may drop
their portfolio weighting in last year's "losing" fixed-income fund. Remember,
equities are more volatile than fixed-income securities, so last year's large
gains may translate into losses over the next year.
Let's continue with Bob's portfolio and compare the values of his rebalanced
portfolio with the portfolio left unchanged.
At the end of the second year, the equity fund performs poorly, losing 7%. At
the same time the bond fund performs well, appreciating 15%, and Treasuries
remain relatively stable with a 2% increase. If Bob had rebalanced his
portfolio the previous year, his total portfolio value would be $118,500, an
increase of 5%. If Bob had left his portfolio alone with the skewed weightings,
his total portfolio value would be $116,858, an increase of only 3.5%. In this
case, rebalancing is the optimal strategy.
However, if the stock market rallies again throughout the second year, the
equity fund would appreciate more and the ignored portfolio may realize a
greater appreciation in value than the bond fund. Just as with many hedging
strategies, upside potential may be limited, but, by rebalancing, you are
nevertheless adhering to your risk-return tolerance level. Risk-loving
investors are able to tolerate the gains and losses associated with a heavy
weighting in an equity fund, and risk-averse investors, who choose the safety
offered in Treasury and fixed-income funds, are willing to accept limited
upside potential in exchange for greater investment security. (Determine your
risk tolerance in Personalizing Risk Tolerance.)
How to Rebalance Your Portfolio
The optimal frequency of portfolio rebalancing depends on your transaction
costs, personal preferences and tax considerations, including what type of
account you are selling from and whether your capital gains or losses will be
taxed at a short-term versus long-term rate. Usually about once a year is
sufficient; however, if some assets in your portfolio haven't experienced a
large appreciation within the year, longer time periods may also be
appropriate. Additionally, changes in an investor's lifestyle may warrant a
change to his or her asset-allocation strategy. Whatever your preference, the
following guideline provides the basic steps for rebalancing your portfolio:
Record - If you have recently decided on an asset-allocation strategy perfect
for you and purchased the appropriate securities in each asset class, keep a
record of the total cost of each security at that time, as well as the total
cost of your portfolio. These numbers will provide you with historical data of
your portfolio, so at a future date you can compare them to current values.
Compare - On a chosen future date, review the current value of your portfolio
and of each asset class. Calculate the weightings of each fund in your
portfolio by dividing the current value of each asset class by the total
current portfolio value. Compare this figure to the original weightings. Are
there any significant changes? If not, and if you have no need to liquidate
your portfolio in the short term, it may be better to remain passive.
Adjust - If you find that changes in your asset class weightings have distorted
the portfolio's exposure to risk, take the current total value of your
portfolio and multiply it by each of the (percentage) weightings originally
assigned to each asset class. The figures you calculate will be the amounts
that should be invested in each asset class in order to maintain your original
asset allocation. You may want to sell securities from asset classes whose
weights are too high, and purchase additional securities in asset classes whose
weights have declined. However, when selling assets to rebalance your
portfolio, take a moment to consider the tax implications of readjusting your
portfolio. In some cases, it might be more beneficial to simply not contribute
any new funds to the asset class that is overweighted while continuing to
contribute to other asset classes that are underweighted. Your portfolio will
rebalance over time without you incurring capital gains taxes.
Conclusion
Rebalancing your portfolio will help you maintain your original
asset-allocation strategy and allow you to implement any changes you make to
your investing style. Essentially, rebalancing will help you stick to your
investing plan regardless of what the market does. (To learn more, read
Achieving Optimal Asset Allocation.)
by Shauna Carther
Shauna Carther is the vice president of content at Investopedia.com. In 2007,
she appeared as a guest on Moneytrack, a Public Broadcasting Service program
devoted to helping consumers learn to invest and take control of their
finances.