The Art of Rebalancing – here’s why it matters to investors

What is rebalancing?

Rebalancing means selling your investments that have performed well to buy other investments that have performed poorly. The idea is to keep the overall shape of your portfolio constant, even if the size changes.

Of course, any changes you make should still be in line with your investing goals and with how much risk you’re happy taking.

Investors should hold a diversified portfolio made up of a range of investments from different asset classes, like stocks, bonds, property, commodities and cash. It’s a simple case of not putting all your eggs in one basket.

More on Diversification

Take a portfolio including a mixture of stocks and bonds for example.

Historically, stocks have delivered high returns but come with a significant degree of risk. Bonds have offered lower returns but are usually less volatile. By combining asset classes, investors can tailor the balance of risk and return in their portfolios to suit their preferences.

How to build an investment portfolio

How rebalancing works

Suppose you decided in 2010 to make your portfolio 50% stocks and 50% government bonds – we’re not suggesting this is a good mix, it just keeps the maths easy.

In the decade leading up to 2020 Global stock markets returned 198%, while UK government bonds returned 69%. That means by 1 January 2020, stocks would’ve made up 64% of your portfolio – not 50%. Remember past performance is not a guide to the future.

When the pandemic struck you would’ve had far more invested in stocks than you had initially planned. So when stocks fell heavily earlier this year, you could’ve lost more than you were comfortable with. At the same time, government bonds actually performed well.  

To avoid this investors can rebalance their portfolios by selling some of what has done well and buying more of what has done poorly, assuming risk and objectives remain unchanged. That way you can keep the ratio of different asset classes in your portfolio constant over time.

Sometimes that’ll mean selling bonds and buying stocks, and sometimes it’ll mean doing the opposite. In some cases you might also want to rebalance between individual stocks. If one of your shares does especially well, it might become a larger portion of your portfolio than you initially intended.

Risk & Return

Portfolio rebalancing is a way of controlling the level and types of risk a portfolio is exposed to. However, there’s also a long  running  debate  on whether rebalancing actually increases returns as well.

Under certain conditions rebalancing could increase returns, but this will depend on the particulars of each case.

For example, after the stock market fall earlier this year, shares could’ve made up a smaller part of your portfolio than they did previously. If you had rebalanced, it would’ve meant buying shares at a relative low point, which is obviously good news for your net worth.

On the other hand, stocks have historically performed better than bonds. A rebalancing strategy would mostly have meant selling stocks and buying bonds and other assets. Over time this would’ve meant lower returns than someone who hadn’t sold their shares. However, it also would’ve reduced the risk of the portfolio – again, there are trade-offs between risk and return.

This is an important thing to recognise. While rebalancing can improve returns under some circumstances, it’s mainly about controlling risk. All investments fall as well as rise in value, so you could get back less than you invest.

How much and how often?

There are two ways to approach rebalancing. You could decide to rebalance at regular intervals, like every six months. Alternatively, you could rebalance whenever the weights of your portfolio diverge by more than a set amount.

You could sensibly choose either, but be aware that trading has costs. If you rebalance too often you’ll end up reducing your overall returns. Ultimately, it depends how comfortable you are with your investment mix changing over time, weighed against the costs of rebalancing your portfolio.

It can help to set rules for rebalancing. It can be counterintuitive, and sometimes psychologically difficult, to sell your best performing investments and buy something that’s not done as well. But past performance isn’t a guide to the future, and just because something’s done well in the past doesn’t mean it will carry on doing so.

This isn’t personal advice. If you think you might need a little more help looking at and maybe rebalancing your portfolio, you could always ask for some financial advice.

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