Portfolio rebalancing is a necessary chore that all investors should consider, but too few do. Portfolio rebalancing is counter to many investors’ behavioral biases. When you rebalance you are often selling your winners and buying your losers. Why would anybody sell their winners and buy more of their losers?
Here Fidelity offers some insight on how rebalancing can help control portfolio risk.
Higher markets and risk levels
Let’s say the last time you decided to rebalance your portfolio was during the bear market in January of 2009. Since then, the market will have made some big changes to the investment mix. The hypothetical portfolio above shows how U.S. stocks went from 49% of the portfolio to 66%, while the proportion of bonds in the portfolio was cut by more than a third.
The challenge for investors is that more stocks come with more risk. By August 2016, the portfolio shown above would have had a risk level roughly 17% greater than the starting mix in 2009. (To measure risk, we use annualized standard deviation; see the disclosure at the end of this article for more details.)
“There is nothing wrong with having more stocks in a portfolio. In fact, many investors need to take on risk to meet their financial goals,” says Sweeney. “But that decision should be a result of your planning process, not dictated primarily by the markets. If you do have a lot more risk than your situation warrants, that could be a recipe for trouble if volatility returns.”
The case for a periodic investment review
Rather than let your investments drift with the markets, it may make more sense to rebalance your holdings periodically—say once or twice a year—or when your mix drifts a set amount from your target. For instance, you may allow your mix to fluctuate a maximum of 10 percentage points above or below the level you target.
For our investment management clients, we employ a flexible approach to portfolio rebalancing that accounts for both asset allocation deviations as well as our outlook for various asset classes and securities.
