It is common for people to make their investments based on asset allocation. The classic example would be a younger investor who chooses to put 20 percent of their wealth in bonds and the remaining 80 percent of their wealth in stocks, which is meant to boost their return without putting their investment portfolio at risk in the process. In contrast, an older investor might go for the reverse with 80 percent in bonds and 20 percent in stocks, which is meant to protect their wealth without cutting their returns to the bare minimum. On the whole, asset allocation isn’t a perfect investment strategy. However, it manages to be simple, straightforward, and useful under a wide range of circumstances, thus making it a very useful one.
Should You Rebalance Your Investment Portfolio?
Unfortunately, asset allocation isn’t an investment strategy that can be used without periodic maintenance. In short, the investments in an investment portfolio built based on asset allocation will see different rates of return, meaning that they will stray outside of the pre-determined percentages with sufficient passage of time. Certainly, investors can just let this happen, but over time, that can seriously undermine their efforts to achieve whatever investment goal caused them to come up with their asset allocation in the first place. Due to this, investors might want to rebalance their investment portfolios for the purpose of restoring their initial asset allocations on a regular basis, thus ensuring the smoothest progress towards their investment goals.
Certainly, this process of rebalancing can take a fair amount of time, effort, and other resources. However, investors should know that there are other potential benefits to it as well. For example, this rebalancing means that investors will always be buying low and selling high because they will be selling off the better-performing investments for the purpose of reinvesting the money into the rest. By doing so, investors can earn a premium on better-performing investments while also putting themselves in a position to benefit from their worse-performing investments when they make a comeback. Please note that while this won’t always make for higher returns, it can have a very beneficial effect on the investment portfolio’s overall risk. This is because rebalancing reduces investors’ exposure to volatile investments, which might come with the potential for higher returns but also come with the potential for lower returns.
With that said, it should be mentioned that rebalancing comes with some costs that make it so that investors shouldn’t be rebalancing on a constant basis. One excellent example would be the commission that investors have to pay their investors, which might seem low but can nonetheless pile up with incredible speed under certain circumstances. Another example would be the taxes that will have to be paid on the gains realized when investments have been sold off. Under these circumstances, investors should remember that while rebalancing can be a useful tool, it is nonetheless one that comes with a price, meaning that it should never be used in a careless manner.
What Are Some Strategies for Rebalancing Your Investment Portfolio?
There are various methods that can be used to determine when to rebalance an investment portfolio. Generally speaking, the most common methods are periodic in nature, meaning that investors will carry out a rebalancing on a quarterly, a semi-annual, an annual, or some other periodic basis. However, there are plenty of other options as well for those who are interested.
For example, some investors choose to rebalance whenever their asset allocation percentage stray past a certain threshold. This can be very useful for people who want a more responsive approach than periodic rebalancing, but it comes with a potential drawback in that it can be very laborious and time-consuming when the market is seeing enormous volatility. Another example of a rebalancing method would be cash flow rebalancing, which is when the investor won’t sell their better-performing investments but will instead invest more in the worst-performing investments when the chance comes up. Something that is particularly useful for younger investors who aren’t in a good position to start withdrawing from their investment portfolios. On top of these, it should be mentioned that some investors can choose to combine these approaches. This can be seen in the combined periodic and threshold version of rebalancing, which means that the investors will check their asset allocation on a periodic basis and choose to rebalance or not based on whether their threshold has been exceeded.