If you always thought that your job is done once your investment portfolio is optimized? Then let us tell you, there’s a long way to go. Your investment portfolio should be reviewed on a regular basis to ensure that it is still consistent with your risk-return profile. And this is when ‘portfolio rebalancing’ comes into the picture. If your risk profile or return expectations have changed, you’ll need to make changes to your portfolio to get it back into line with your investor profile. This is what rebalancing your portfolio is all about.
Let’s dig a little deeper into this topic to see what exactly is portfolio rebalancing, how does it work, why is it important, and a lot more.
What is Portfolio Rebalancing?
When putting together a well-balanced investment portfolio, you take into account the performance of different investments and evaluate their potential returns. Even so, some of your investments may underperform or overperform over time. Your risk tolerance, spending habits, and personal and financial goals may also change as you get older. As a result, you should review your portfolio to ensure that it is in line with the market and your objectives. In the process, you must concentrate on not exposing your portfolio to undue risk and ensure it is relevant to new trends. As a result, you substitute underperforming investments with ones that display more potential.
How Does Rebalancing Work?
The primary goal of portfolio rebalancing is to protect the investor from exposure to unfavorable risks. Rebalancing the portfolio on a regular basis holds the risk in line with the investor’s risk tolerance. As a result, rebalancing the portfolio to meet the current needs is necessary. There are three options an investor can rebalance the portfolio – Periodic Rebalancing, Threshold Rebalancing and Allocation of New Funds. It’s important to choose the best rebalancing strategy for you.
Here’s a quick look at the three portfolio rebalancing strategies:
Choose a time to revisit your investments and stick to them. Make it a point to review your assets at least once a year. Periodic rebalancing is beneficial because it instils consistency and takes less time. One disadvantage is that the investor can lose out on a great market opportunity.
Portfolio rebalancing is taken a step further with threshold rebalancing. It allows investors to rebalance the investments only when it actually counts. This makes use of the Allocation Deviation Threshold concept, which specifies how far the investments have differed from the overall goal allocation.
Allocation of New Funds
Instead of selling the high-performing assets, the investor will put more capital into the portfolio to rebalance it. To put it another way, the investor should inject capital into the appropriate asset class to preserve the desired asset allocation. Deposits at regular intervals will aid in periodic rebalancing as well as instilling financial discipline. By allocating new funds to rebalance, one is confident that the high-performing assets will continue to perform well.
Why is Rebalancing Important?
Portfolio rebalancing’s main goal is to improve risk management and ensure that your portfolio is not solely reliant on the performance or loss of a single investment. For an investor, rebalancing is a risk-mitigation technique. It helps to align the investments with the investor’s objectives by rebalancing the portfolio on a regular basis. How to Rebalance Your Portfolio? Your investment needs and priorities will determine how you rebalance your portfolio.
However, following a few basic steps will assist you in good perspective of the procedure.
1) Establish a target asset allocation. To make your asset allocation compatible with your investor profile, consider your personal and financial goals, risk appetite, and retirement goals.
2) Create your investment portfolio based on the asset allocation you need.
3) Examine your portfolio at regular intervals to see if the investments are still following the original asset allocation.
4) Ensure that your asset allocation target is in line with your life goals by revisiting them on a regular basis.
5) If your target asset allocation is not aligned, you will need to buy new units of certain assets or sell some units of other assets as required before the correct asset allocation is restored.
Periodic rebalancing is the best way to recognize, track, and eliminate associated risks in order to create a diversified and powerful portfolio. Many investors favour the rebalancing portfolio approach because it helps them to remain on top of the game. Markets, on the other hand, are competitive, and certain factors including social, financial, economic, etc., may all have an impact on how your investments perform. Be sure to keep a close eye on the results of your portfolio and implement some useful rebalancing techniques based on your priorities.