When building an investment portfolio, one of the most important decisions is deciding how your money should be invested.
After discussion we provide advice on how your portfolio should be made up of a certain combination of shares, bonds, and cash. The right balance will depend on your circumstances, your objectives, the level of risk you are comfortable taking and what your capacity for movements and losses are.
But once that portfolio has been created, it doesn’t simply stay in the same position. Different investments perform differently over time. If shares rise significantly while bonds remain relatively stable, the proportion of your portfolio invested in shares will increase. What started as a portfolio with a carefully considered balance could gradually become something quite different.
This is where rebalancing comes in.
What is rebalancing?
Rebalancing is simply the process of bringing your investment portfolio back towards its original or intended asset allocation.
Imagine you have a portfolio that was designed to be 70% invested in shares and 30% in bonds. If shares perform particularly well, you might eventually find that your portfolio is 80% shares and 20% bonds. Nothing has necessarily gone wrong. In fact, you may be pleased that your investments have grown. However, the portfolio is now taking more risk than it was originally designed to take.
Rebalancing would involve reducing the amount invested in the assets that have grown in value and increasing the amount invested in those that now make up a smaller proportion of the portfolio. The aim isn’t to predict what will happen next. It is simply to bring the portfolio back towards the level of risk that was originally agreed.
Why is rebalancing important?
The biggest benefit of rebalancing is that it helps keep your portfolio aligned with your financial plan. Investment markets don’t move in a straight line, and different parts of your portfolio will perform differently at different times. Without rebalancing, these differences can gradually change the characteristics of your portfolio.
A portfolio designed around a particular level of risk can therefore become either more or less risky than intended. Rebalancing also creates discipline. It means you aren’t simply allowing your portfolio to become increasingly concentrated in whatever has performed best recently. Instead, you’re periodically bringing it back towards the allocation that was chosen for a reason.
This can sometimes feel counterintuitive. If one part of your portfolio has performed particularly well, why would you sell some of it? The answer is that rebalancing isn’t about deciding that the investment which has performed well is suddenly a bad investment. It is about recognising that its strong performance has changed the balance of the overall portfolio.
What happens if you don’t rebalance?
The implications of not rebalancing depend on what happens in markets, but the main risk is that your portfolio gradually moves away from the level of risk you originally intended to take. For example, if shares perform strongly over several years, a portfolio that was originally designed to have a balanced exposure to shares and bonds could become increasingly dominated by shares.
That may be perfectly fine while markets are rising. The problem becomes apparent if markets subsequently fall. You could then experience a larger fall in the value of your portfolio than you had originally planned for, simply because you were taking more investment risk than you realised or intended.
The opposite can happen too. If shares fall significantly, their proportion of the portfolio will decrease. Without rebalancing, you could end up with less exposure to shares than your long-term plan requires. So, in simple terms, not rebalancing can mean that your portfolio gradually stops looking like the portfolio you originally decided you needed.
Why do we typically rebalance annually?
There is a temptation to think that if rebalancing is a good thing, we should do it as often as possible. But we don’t think that is necessarily the case. Rebalancing too frequently can result in unnecessary transactions and, depending on how it is carried out, can mean parts of your portfolio are temporarily held in cash while changes are made.
More importantly, we don’t want to be constantly making changes to your investments. Markets move every day. If we tried to rebalance every time your portfolio moved away from its target allocation, we would spend a considerable amount of time reacting to short-term movements in markets.
That isn’t what financial planning is about. Instead, we typically look to rebalance portfolios once a year, unless there is a specific reason to do something differently. This provides a sensible balance. We are regularly checking that the portfolio remains aligned with the financial plan, while avoiding the temptation to constantly interfere with it.
It also helps us avoid unnecessary periods of being out of the market. When you sell one investment and wait before buying another, there is a risk that markets move during that period and you miss out on some of the recovery or growth. We would much rather have a clear, planned process than constantly make investment decisions based on what markets have done recently.
It’s about discipline, not prediction.
Perhaps the most important thing to understand about rebalancing is that it isn’t an attempt to predict which investment will perform best next. We don’t know whether shares, bonds, or any other asset will perform best over the next year. Neither does anyone else with any certainty.
Rebalancing is simply a way of maintaining the portfolio you decided you needed when your financial plan was created. Markets will move and your portfolio will move with them. From time to time, that movement will cause the balance of your investments to change but rebalancing brings things back towards where they should be.
It’s another example of why good investing is often less about trying to make clever decisions and more about having a sensible plan and sticking to it.
*Investments carry risk.
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