Rebalancing an in Vestment Portfolio

Investment advisors recommend that an investment portfolio is diversified across a range of investments. This is to ensure that the investor has a balance of short and long term investments, and has taken an appropriate balance of risk and reward to reflect their personal needs and risk appetite.

Investments are usually diversified across a range of bond, equity, property, commodities, cash and geographic region.  Good investors know their appetite to risk and establish target percentages of their wealth to be held in each class. Investors adverse to risk tend to have a higher holding in bonds. Investors who are less risk adverse are recommended to maintain a higher proportion of equities. Investors in their thirties are encouraged to have a higher holding in equities than an investor approaching retirement. The reasoning is that a younger investor can benefit from the long term appreciation of shares whereas an investor approaching retirement, and a need to draw down upon his/her investments is more likely to be exposed to adverse market fluctuations.

Good investors need to regularly value their investments to ensure that they remain within their target percentages of the overall portfolio. This is because, depending upon market conditions, some asset classes will outperform other classes in the portfolio.

Investors may also wish to rebalance their portfolio to reflect changing market conditions or to reflect changes in their personal circumstances. In volatile markets investors might wish to hold more cash than would be the case in calm markets. Investors might wish to adjust their proportions held in corporate bonds or equities to reflect economic conditions. As people approach retirement they should be re-weighting their portfolio towards bonds.

Apart from rebalancing the risk profile of the portfolio there are other sound reasons for periodically rebalancing a portfolio. It is a good discipline which focuses the investors mind. What does he expect from the process? The process supports a buy low, sell high policy. It avoids being caught in a speculative bubble. For example, over the past few years commodities have had a bull run meaning that diversified portfolios are likely to be overweight in commodities. A sell off to rebalance the portfolio might be desirable to lock in profits. Understandably investors are much more reluctant to rebalance a rising asset class than an underperforming one. If the portfolio is not rebalanced the portfolio will gradually build un an undue concentration in the rising asset class. This can seriously distort the risk profile of the portfolio.

Rebalancing can be approached in two ways. Assets within an overweight class can be sold so that the proceeds are available to buy assets in an underweight class. Alternatively new investments can be directed into the underweight class. Investors must decide whether to complete all the rebalancing transactions at once or over a period using a drip in drip out strategy. The later avoids the market timing problem that one might chose to buy and sell on an unfavourable day.  

Investment advisors usually recommend an annual review ands rebalancing exercise. More regular reviews are necessary in volatile market conditions.  Portfolios that have investments in closely correlated asset classes need to be revalued more frequently than portfolios that contain uncorrelated assets. Many investors set aside a set date each year in which to review their finances. It is a popular exercise that take place between Christmas and the New Year.

Investors need to be careful to regularly balance the portfolio without being drawn into excessive churn and commission charges. It is important to remember that rebalancing is part of an investment strategy in which new investments are chosen for well thought out reasons for the medium to long term rather than as a short term speculation.

Some investors use their regular rebalancing exercise to rebalance their portfolio on much broader criteria other than market value. This enables them to pursue more specific investment strategies. Generally asset class allocations are conducted on a market valuation basis, with some year on year variations to reflect market conditions. Other criteria can be used to fine tune the investments within each asset class. A high yield investor typically seeks to replace shares that have a falling dividend yield with shares that offer higher yields.

Mutual fund investors should note that the fund already carries a measure of diversification. Mutual funds specialise in particular asset classes and invest in a spectrum of opportunities within that class. More general diversification involves investing in a range of mutual funds. Some mutual fund operators operate a low cost switching policy to enable investors to balance their portfolio for within a stable of funds operated by the fund manager. Otherwise, rather than incurring selling and commission charges, an investor is best advised to re-balance the portfolio be ramping up, or reducing the monthly contributions placed in particular funds.

 A regular rebalancing of an investment portfolio is an essential discipline for a serious investor. It mitigates against risk and increases the focus upon the underlying objectives of the portfolio. Rebalancing involves adjusting the relative weights of assets within a portfolio. It does not concern itself with stock selection.