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Rebalancing your portfolio is important to understand for DIY investors looking to build long-term wealth. When building an investment portfolio, you usually choose diversified asset classes (stocks, bonds, ETFs, etc.) and an allocation for each of them. Over time, your portfolio allocation shifts with the markets and could be very different from what you intended. This is when rebalancing is needed.
This article will cover all you need to know about rebalancing: What is it? Why is it important? When should I and how often should I rebalance?
What is Portfolio Rebalancing?
What is the Most Recommended Frequency to Rebalance your Portfolio
When you create an investment portfolio, you have to decide on an asset allocation. A typical balanced portfolio will consist of both equities (e.g. stocks) and fixed income assets (e.g. bonds). Your allocation between the two will depend on the performance you want for your portfolio, your risk tolerance, and time horizon.
Generally, stocks are seen as riskier and more volatile, but they tend to have higher return potential than bonds. Most investors start their investment life with mostly equities and gradually increase their proportion of bonds. This is because the more time you have, the more you (in theory) can withstand the swings of the market. This will also depend on the individual investor’s appetite for risk. A commonly accepted rule of thumb is to use your age as the proportion of fixed income. For example, a 40 year old will have 40% of bonds, and 60% of stocks in their portfolio.
Sooner or later, your portfolio will go through market fluctuations, and the allocation of assets relative to each other will change. Rebalancing is simply the process of realigning the weightings of a portfolio’s assets to their desired allocation. You do so by selling the overweight assets and buying the underweight ones.
Why is Rebalancing Important?
The main purpose of rebalancing is to maintain the desired level of risk of a portfolio. Let’s say the stock market is doing well and all your stocks have been increasing in value. Your allocation in stock would go up relative to your allocation in bonds, which would increase your risk level as well. If, on the contrary, bonds were doing better than stocks, then your potential returns may start to fall short of your expectations.
The other reason for rebalancing is that it allows you to “lock in” gains of over-performers while buying under-performers at a low price. In a bull stock market for example, rebalancing would mean selling some of your increased value stocks to buy more bonds, allowing you to realize profits on your stocks.
One thing to note is that rebalancing is not meant to maximize profits but rather to balance portfolio risk. In a bull stock market, you may be tempted to let your stocks go even higher instead of selling them to buy bonds. However, doing that would expose you to more risk than you intended when setting up your portfolio allocation. Additionally, there is no way to know how high that particular would go, or when it may start decreasing in value. If you tried to time the market, your returns could be higher, but you could potentially also lose money.
Setting a portfolio allocation and rebalancing regularly allow you to make decisions on your investments without emotions getting in the way.
When Should I Rebalance my Portfolio?
And the best way for emotions not to get in the way is to have a trigger for rebalancing.
Some investors prefer to rebalance at regular intervals: once a month, once a quarter, once a year. This is a good strategy if you don’t want to constantly monitor your investments. Set an alarm to rebalance and don’t think about your portfolio the rest of the time. The downside to this strategy is that markets can shift multiple times between two rebalancing’s. Not only your portfolio may become exposed to more risk than you wish for, you may also leave some opportunities to buy low/sell high on the table.
This is why some investors prefer rebalancing when their portfolio’s allocation drifts by a certain percentage (often 5%). When you rebalance based on percentage drift, your portfolio will always reflect your strategy and risk tolerance.
You could also do a mix of time and drift based trigger. For example, you could decide to rebalance quarterly, only if your portfolio drifted by 5% or more.
Important Considerations When Rebalancing
Rebalancing consists of buying and/or selling assets, and some of these transactions can make you incur fees. Fees can be a massive drag on portfolio performance, so it’s important to try to minimize them.
One way to minimize fees is to build an ETF portfolio, such as the Couch Potato portfolio or Canadian Couch Potato portfolios, and rebalance by contribution only. ETFs buys are commission free at most online brokerages and buying the underweight assets is often enough to bring your portfolio back to its target allocation.
The other advantage is that you save on taxes since you only owe taxes when you sell assets.
In the US, short-term capital gains are taxed at the rate of your income tax bracket, while long-term capital gains are usually taxed at a lower rate, so it’s generally better to hold assets for at least a year before selling.
In Canada, you are taxed at your marginal rate (meaning, your highest personal tax rate) on half of the value of any capital gains. If you realize your capital gains after you retire, your marginal rate should be lower than in the middle of your career.
Speaking about taxes, another way to minimize performance drag on your portfolio is to avoid unnecessary taxes. Make sure to maximize your contributions to non taxable registered accounts first.
Whether you choose to rebalance at a certain frequency, or when your portfolio gets a certain amount out of balance, A tool like Passiv can help you keep your portfolio on target painlessly in under a minute.
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