For most, investment is largely regarded as a way to create passive income. While we try to make profits, minimising risk is, at the same time, hugely important.
This is where portfolio rebalancing comes into play.
Unfortunately, many tend to fixate on what to invest in, and end up overlooking the process of rebalancing their existing investment portfolios.
While you can construct your portfolio yourself, it could be easier for some to engage a professional fund manager or stock broker at a fee to help you.
We will delve more into what is portfolio rebalancing in this piece, looking at the reasons and importance for doing so, and the different ways you can maintain a diversified portfolio.
Firstly, what is an investment portfolio?
An investment portfolio consists of a mix of asset classes comprising equities, fixed income, alternative investments, and in some cases, even real estate.
Read more: Investment Asset Classes Explained
Depending on your risk profile and investment goals, you would typically invest in different asset classes at various allocation levels. This offers a balance between riskier and more stable returns. You can change the allocation levels whenever you want, adjusting them to your current risk appetite and goals.
As the markets change, you can make adjustments to maximise your investment portfolio’s returns. These adjustments will also help you hedge risks over time. After all, the purpose of asset allocation is to balance risk and reward, and to make sure your investment is diversified.
What is portfolio rebalancing and why is it important?
When you first decide and commit to an investment strategy, the asset allocation in that strategy is what you considered to be best suited for your current risk appetite and investment goals.
Portfolio rebalancing is the process of buying and selling parts of your portfolio to change the weightings of each asset back to its original state. It allows you to continue investing in a risk range that you are comfortable with.
It also helps you to “buy low, sell high”, aiding you in reaping profits from your investment.
For example, your stocks are now taking up 85% of your portfolio instead of the initial 50%, which means that they are doing very well. Rebalancing means selling them and buying more of other asset classes, such as bonds, to bring your portfolio back to the original desired allocation and risk level.
Additionally, if your investment strategy or risk tolerance has changed, portfolio rebalancing also allows you to adjust the weighting of your assets to fulfil the new strategy.
When should I do a portfolio rebalancing?
You should at least check your portfolio allocation every six months but you do not have to rebalance the moment your allocation sways a little away from your target.
In fact, messing with your investments too much can lead to mistakes. If you look at your investments too frequently and worry about the slightest changes, you are likely to make poor choices leading to irrational decisions.
Here’s an example of portfolio rebalancing for Alex, who has a balanced risk appetite portfolio. He asked for a 50-50 split between equity and bonds and invested $1,000 at the start of the year.
|FUND/STOCK||UNIT PRICE||UNITS PURCHASED||AMOUNT INVESTED||PERCENTAGE|
Towards the year of the year, Alex looked at his investment portfolio and realised both assets have performed differently. His new investment portfolio now looks like this:
|FUND/STOCK||UNIT PRICE||UNITS PURCHASED||AMOUNT INVESTED||PERCENTAGE|
The asset allocation after a year has deviated from Alex’s initial plans. Over the course of the year, the market value of each item within his portfolio performed differently, earning a different return, and resulting in a change in their allocation.
The current portfolio has become riskier than before, with the equity asset taking up 63.15% instead of the prescribed 50% that he was comfortable with.
This is where rebalancing comes in. If this is not done, a sudden dip in the unit price of the equity asset will result in a larger loss as compared to a portfolio at the original 50-50 split.
How should I rebalance?
Begin by letting go of asset classes that are performing well, and purchasing investments that are not. This may sound counterintuitive, but it is key to managing risk.
Many investors find it hard to let go of their “winning” investments, but selling high is a great way to secure your investment profits. Selling assets that have possibly already reached their peak would allow you to cash in on those gains and free up funds to purchase other assets that may be lower in price and primed for growth.
Different ways to maintain a balanced portfolio
Some may choose to invest independently, while others go through brokers or investment managers.
Choosing to invest independently can save you money as it removes the middleman and saves on the fees you would otherwise need to pay. Doing it yourself also means you have full control over what assets to purchase, sell, and when to do so.
If you have an existing pool of investments, start off by checking if the initial growth of your portfolio is off-target. Consider selling off the assets that have outperformed their growth target. Purchase asset classes that have underperformed.
However, investing independently will be time-consuming as you need to set up an e-trading account, analyse every investment yourself, and decide on when and how you should rebalance your portfolio.
Another downside: the lack of professional management advice and access to a wider pool of investment assets that are otherwise available through other methods. For instance, certain stocks are only open to institutional investors, or out of reach for most individuals’ budgets.
Alternatively, you can use unit trust fund managers, through whom you would buy into funds with fixed asset allocations. Unit trust funds are a mix of investments across asset classes that are held under a trust deed, also known as a mutual fund.
The advantage of unit trust funds is the access to a wide variety of asset classes that you might not typically have access to due to a lack of capital. Through a unit trust fund, you can invest in an existing pool of risk-optimised asset classes and securities.
In recent years, robo-advisors have also grown in popularity.
The main draw to them is the low minimum capital to start, which could be as little as $100 per month. They also tend to charge lower management fees, of around 0.5% to 1% per year on average.
Read More: Best Robo-Advisors
These systems utilise algorithms to systematically buy and sell assets according to your desired growth targets and risk profile. Simply put, a computer watches and trades on the market’s movements with minimal human intervention.
In order to fully maximise the potential of your portfolio, keeping track of how your investments are performing and rebalancing your portfolio every few months is recommended.
Rebalancing helps you stick to your investment strategy regardless of how the market performs, which also makes sure you are investing within your risk tolerance levels.
While you’re setting money aside for investing, don’t forget to figure out how much you need to put aside for emergencies using Planner Bee’s emergency fund calculator.