Portfolio Rebalancing: As Critical As Diversification

portfolio-rebalancingDiversification is a fundamental tenet of smart investing that’s been pretty well instilled in the psyche of even casual investors.
Don’t put all your eggs in one basket. No matter how much you believe a stock like Apple (NASDAQ: AAPL) might continue to grow, you don’t want to put all your money into Apple shares.
There is a corollary to the principal of diversification that’s a little less widely known and followed, but is also important. It’s called portfolio rebalancing – that is, periodically checking in with your portfolio to ensure that it’s roughly balanced the way you intended it to be.
Here’s a super simple example of what can happen to your portfolio if you don’t rebalance it. Say you decided to put your portfolio assets into three buckets: stocks, bonds and cash. Now, let’s say the first year after you diversify in this manner, the value of your bonds and cash stay virtually unchanged, while your stock holdings double (not likely, but I’m trying to keep this example simple). Suddenly, your stock holdings account for half of all your assets, rather than the third you were planning on.
Now, it’s tempting in such a scenario to reason that it’s perfectly correct to own more of a good thing, and that no adjustment is necessary. But this way of thinking is flawed for a couple of reasons.
First, consider the cliché, past results are no indication of future performance. This is particularly true for the stock market. No stock can grow forever, and even high-growth companies will sooner or later mature and assume a different, likely lower rate of growth – or worse, start losing ground.
Now, if you’ve continued to let your stock portfolio grow relative to your overall holdings, you’re putting your entire portfolio at risk. Stocks could start to decline, and suddenly (again using our over-simplified example) your largest asset class is losing ground and pulling down your whole portfolio. Or, imagine that your fixed-income holdings suddenly start to grow rapidly: If you’ve let that asset slip as a share of your overall portfolio, you’ll be missing out on some gains.
The fact is you can never predict with certainty which assets will expand and which will contract, but your best strategy for seeing steady growth is to carefully select your investments, diversify, balance and regularly rebalance.
Keep in mind that portfolio rebalancing is not about constantly buying and selling assets, but rather about periodically checking in. Follow these simple steps:

  1. Decide on an allocation. Too often, investors arrive at their allocations almost accidentally, and they see how their holdings break down only after they’ve made their investments. Ideally, you should take the reverse approach, and invest in stocks, bonds, real estate, etc., based on your long-term goals, your investment time frame and your tolerance for risk. Being clear on these goals will help you understand how you should allocate your portfolio, which will be pivotal to recognizing when it’s out of balance.
  2. Set a date and mark your calendar. For most investors, an annual check-in should suffice, barring unusual circumstances like extreme bear markets. If you are particularly hands on, you may want to do this twice a year, but any more than that could be counterproductive. But once or twice a year, make a point of checking in to see how your allocation compares to your plan. If what started out as a third of your assets in stocks has dropped to 30%, that’s well within range and no cause to reallocate. But it will help signal that you may be veering off course, so that you can keep close watch.
  3. Consider the cause of the imbalance. There are two reasons that your portfolio will become unbalanced. Either some assets are growing faster than the rest, or some assets are struggling. Think about that for a moment, and you’ll realize it’s a matter of perspective. But to determine the right course of action, it’s also important that you distinguish between an imbalance caused by a runaway success, and one that results from a dog of an investment.
  4. Take profits. If your stock holdings are growing so fast that they are overtaking your portfolio, you should consider a step that may sound counterintuitive: sell some of those shares. If you own a stock that’s run up considerably, realize that that pace of growth might not continue. Think about selling at least some of these shares and taking your profits. You will, of course, run the risk of missing out on more runaway gains, but rational investing isn’t gambling, and it’s better to be balanced.
  5. Cut your losses. Just as profit taking is a key element of rebalancing your portfolio, so too is cutting your losses. Slow and steady may well win the race, but a bona fide loser probably won’t catch up. Know when to hold ’em and when to fold ’em. When you must sell, take the opportunity to invest in something else that will help you achieve greater balance.

Rebalancing doesn’t need to be difficult, but it won’t happen automatically. To borrow a popular slogan, just do it.

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