Rebalancing Portfolios

Rebalancing a portfolio is an important factor in achieving long-term returns. If you accept that your risk capacity should be matched with a suitable portfolio then rebalancing is the means by which you maintain a consistent risk exposure.

For example, after a prolonged bull market the balance of equities and fixed income in your portfolio might have shifted from 60/40 to 70/30 – leaving you more exposed to the downside than you are prepared for.

Although rebalancing is a simple concept, realising its benefits is a challenge for many investors because it involves selling assets that have recently done well and buying assets that have recently done poorly in order to return to the original allocations.

However, an understanding that, over the long-term, asset class performance tends to be mean revert (i.e. periods of above average performance are followed by periods of below average performance) rather than maintain upward or downward trends indefinitely, will help the investor overcome his reluctance to do what appears to be counter-intuitive – i.e. sell a successful investment rather than hold on to it.

Rebalancing has been proved to increase portfolio returns with no additional cost in terms of risk. However, it is not an entirely ‘free lunch’ as, in order to rebalance, some transactional fees and expenses may be incurred.

The key, then, is to maintain discipline as to when and why the portfolio will be rebalanced. As a general rule, a portfolio is tested quarterly and rebalanced when necessary – usually on an annual basis to revert to its original allocation.

In addition, your risk capacity should be measured annually or when a significant life event occurs: loss of job, marriage, divorce, birth of children or death, to determine whether any structural change in asset allocation is required.