Revisiting your allocation helps keep your financial plan aligned with your goals, risk tolerance and time horizon.
When your portfolio is first constructed, it will ideally reflect your investment objective – a combination of your goals, risk tolerance and time horizon. Unless something changes, your portfolio should continue to align with those objectives. That’s where rebalancing plays a key role.
The investments in your portfolio generally grow at different rates. Typically, more volatile, or risky, asset classes come with higher returns, which means those asset classes may grow at a faster rate than less volatile asset classes. As those more volatile assets grow, they begin to take up a larger percentage of your portfolio than they originally did – meaning your portfolio’s overall risk may now be higher than you originally intended. Rebalancing is the practice of bringing your portfolio back to its original asset mix, or allocation, to restore the appropriate risk level.
There are various approaches to rebalancing, ranging from making no changes to setting very specific volatility-based limits around the different asset classes in your portfolio. Choosing a rebalancing approach calls for careful deliberation, and you should consider the impact it will have on maintaining your portfolio’s intended risk and return characteristics.
Buy and hold is the simplest approach. Once your assets are invested, no changes are made, and the assets are free to move with the markets. The assets with the highest returns (which are likely those with the highest risk) will grow the most, which can increase the risk of your overall portfolio.
With a time-based or constant mix approach, asset class proportions are brought back in line at regular intervals, such as monthly, quarterly or – mostly commonly – annually. Bear in mind that choosing to rebalance more frequently can mean more transaction costs, paying taxes on short-term capital gains and a potential loss of returns if an asset class is not given sufficient time to meaningfully appreciate.
A drift-based or contingent approach sets a threshold, also known as a tolerance band, around each of the asset classes in your portfolio and rebalances whenever a threshold is breached. Bands can be relative or absolute. For example, setting a 10% relative band around a 40% allocation would trigger a rebalance at 44% or 36%, while a 10% absolute band would allow the allocation to drift up to 50% or down to 30% before rebalancing.
In addition to costs associated with monitoring and trading, there are other factors you should consider when evaluating rebalancing approaches.
Asset class volatility: More volatile, or riskier, asset classes will breach tolerance bands in either direction much more often than less volatile asset classes. As a result, it may be more efficient to set a wider band around more volatile asset classes, unless you prefer the more frequent rebalancing.
Asset class weighting: With absolute bands, asset classes with small allocations must increase significantly to trigger a rebalancing event. Relative bands self-adjust based on the weighting of the asset, which many consider an efficiency advantage.
Other considerations: Tax implications, market conditions and the objective of the portfolio are examples of important factors to consider when rebalancing.
Rebalancing your portfolio is key to helping maintain an appropriate level of risk. Talk with your advisor about the different approaches – he or she can help you determine which method best suits your unique financial plan.
There is no assurance any investment strategy will be successful. Past performance may not be indicative of future results. The process of rebalancing may result in tax consequences.