When it comes to investing, experts say you should not put all your eggs into one basket. However, there are so many options in the market that it can be overwhelming to decide the right strategy for your money. As important as it is to choose wisely, it is equally important to track it consistently. It will help you understand the current state of affairs and make modifications, if necessary. Another thing that can help you is rebalancing your portfolio.
What is portfolio rebalancing?
To understand this, let’s assume that you have invested 80% of your money into stocks and 20% into bonds. You arrived at this balance after considering the risks you could afford. After a couple of years, you notice that your investment into bonds has grown and the proportions have skewed. To rebalance your portfolio, you sell some of your bonds and buy stocks to maintain your asset allocation. These adjustments and tweakings are called portfolio rebalancing.
Why is it important to rebalance your portfolio?
It is advisable to determine your asset allocation strategy before you start investing your money. Asset allocation refers to your plan of putting your hard-earned money into different asset classes such as stocks, bonds, cash, etc. You can take help from an expert if you do not have the right information to decide the asset allocation strategy for yourself.
The primary objective of asset allocation is to protect yourself from risks and increase your overall returns. You may have a higher risk appetite when you are young. However, your risk-taking ability may decline as you get married and have children. Similarly, you can afford to invest in stocks which are considered to be risky if you have a longer time horizon. Although they are risky, they also give higher returns over a long period. On the other hand, if you are in for the short-term, you may want to allocate a significant proportion to bonds that are considered to be a safer option. Besides, every individual is different and handles failures differently. Your portfolio manager or financial advisor will consider all these aspects before deciding the right asset allocation strategy for you.
In this scenario, when so much thought goes into deciding your asset allocation strategy, it is important to review your portfolio at least once every year. The purpose of rebalancing is to protect you from undesirable risks. Besides, your life-stage or financial needs may change over time. Rebalancing will help you to adjust your portfolio accordingly. Lastly, relooking at your portfolio will allow you the opportunity to sell high and buy low. You can gain from your high-performing assets and sell the low-performing ones. You can re-invest the gains to maximize your returns.
How can you rebalance your portfolio?
Let’s look at two ways of rebalancing your portfolio.
- Manual rebalancing – You can consider this approach if you are keen on handling your portfolio yourself. This is a more hands-on method which will need certain time-commitment from you. Experts in the field tend to revisit their portfolio once every quarter. This strategy may not work for you if you do not have the right knowledge to evaluate and adjust your asset allocation. Besides, you will need to have a strong will-power to pull out from an asset class that is performing well.
- Automatic rebalancing – You can opt for lifecycle funds if you want to outsource the task of rebalancing your portfolio. The asset allocation in these funds changes with your age and risk tolerance. For instance, if you are a long way from retirement, you can afford risky investments. The proportion of these risky assets will go down as you inch closer to retirement.
Portfolio rebalancing is as important to your investment as your yearly medical check-up is to your health. It can raise red-flags and allow you to take corrective steps in time. Moreover, you can stay on top of your finances and accommodate your changing financial needs. You can either do it yourself or take an expert’s help to realign your financial objectives from time to time.