Step 72: Rebalance your Portfolio

This and the next step look at managing your assets in your portfolio on a long-term basis to ensure they remain aligned with your goals. With time some assets might grow faster than others, goals might change or you might want to change the risk level of your portfolio the closer you get to your goals. In all cases this can be dealt with by rebalancing your portfolio and re-allocation your assets. Similar to the investing principle of “buy when everybody else is selling”, which we discussed in step 54, the rebalancing of your portfolio is another investing concept which is easy to understand and execute logically, but can be difficult to implement psychologically.

Yearly rebalancing

The yearly rebalancing of your portfolio ensures that if one area of your portfolio does really well in one particular year, you don’t deviate too much from the original asset allocation that you had in mind for your portfolio. If one assets grows much more than another, it might make your portfolio too volatile or too safe for your goals and risk tolerance.

Let’s look at an example and assume that you want a 70% shares and 30% bonds allocation in your portfolio. You put in $10.000 and the moment you enter the market both bonds and shares happen to be $100 per unit. Ignoring costs for the sake of this example, that means you’d have $7.000 in shares and $3.000 in bonds. A year later the shares have far outperformed the bonds, and even though both have gone up in prices, your bonds are now worth $3150 (a 5% increase), whereas your shares are now worth $8050 (an increase of 15%). The stocks and bonds allocation is now no longer 70/30 but 72/28. Not a huge difference you might think but if the shares keep outperforming bonds by that much for a few years, you might end up with an 80/20 portfolio in just a few years.

That might become too risky for you as you might suddenly have more of your money in stocks than you want, making your portfolio very volatile. (The opposite of course happens if bonds outperform your shares). Presumably you started with a 70/30 allocation for a reason, as that was probably the optimal risk / return balance that you were looking for.

Rebalancing strategies

This is where the rebalancing of your portfolio comes in. When you rebalance you return to the original distribution of shares vs bonds that you had in mind, in this case 70/30. You can do this in two ways:

• Selling some of the assets that produced greater results, in our example this would be the shares, so you’re back on your original asset allocation. This has two advantages in itself:
  • It allows you to liquidate the good returns for that year by selling some of those assets (remember your $8050 might go down in a few months if share prices drop so selling lets you take advantage of the current high of these shares);
  • You are able to buy the lagging asset at a cheaper price (remember your shares are more expensive now as they went up with 15% so are now worth €115 whereas any bonds are €105 after their 5% increase, so bonds are relatively cheap to purchase compared to shares). You are essentially freeing up money to buy some cheaper assets – bonds in this case.
• Alternatively, if you are also investing on a monthly basis, you can stop buying new shares for a while and just buy bonds until the original allocation is back to 70/30 again. This might take longer to achieve but the advantages of this approach are:
  • you don’t pay taxes on the capital gains you would have gotten from strategy 1 the moment you sell some of your shares.
  • You are not parting with your shares that are doing so well. Strategy 1 forces you to sell some of those shares that have given you pretty decent returns and it might be psychologically difficult to sell shares after they just made you lots of money.

Either strategies can prove to be difficult to implement as you are “sacrificing” your strong assets in favour of the weaker ones, which of course is a tough psychological decision to make. But if you want to make sure your portfolio is still aligned with your goals, you want to avoid getting an allocation of assets that is very out-of-balance compared to what you started with and which you decided was your ideal distribution.

Generally speaking, rebalancing your portfolio just once a year is usually a good time frame to work off to give your assets some time to develop and profit from possible increases in the market whilst at the same time not letting your portfolio get to an asset allocation that is way off what you had in mind.

Step 72 – Asset Allocation – in detail:

• Decide on the ideal asset allocation in your portfolio: what percentage do you want to have in stocks and in bonds respectively?
• Look at your current portfolio and see how it compares to your ideal allocation.
• Determine a yearly rebalancing date when you can rebalance your portfolio. The end of the year or just before filing taxes can be a good time but of course this can be any time.
• If you have different markets in your portfolio (for example an US stock index, a European index and an upcoming markets index), you can apply the rebalancing to the different indexes too. For example if the upcoming markets did a lot better than your US index, consider selling a part of the upcoming shares and buying more US ones.

Rebalancing your portfolio is a great and easy way to realign your investments with your goals and plans long-term. In the next step we’ll take a close look at how to manage your portfolio when you get closer to retirement.

Read more about my 100 steps mission to financial independence or simply decide to take control today and join us on our step-by-step quest on how to make your finances work for you, starting with step 1.