When and Why to Rebalance your portfolio?
Everything around rebalancing starts with a notion that we start with a portfolio that is ‘optimal’. Then as time elapses, investor constraints change or the market changes the portfolio composition shifts and the allocation hence becomes sub-optimal.
The basic benefit of Rebalancing is that it restores the portfolio to its theoretically optimal asset weighting. Investors need to rebalance their portfolios to manage risk and earn returns planned for.
Financial planners suggest investors to rebalance their portfolios once a year or whenever there is a sharp movement in a particular asset class. If you don’t rebalance, you may find yourself overexposed to a market fall in one particular asset class.
Consider a simple hypothetical portfolio, with a target allocation consisting of 60% stocks and 40% bonds.
Over the last three years equity returns have sharply outpaced those of fixed income, 41% to 4%. As a result, the hypothetical portfolio today would consist of 67% stocks and 33% bonds.
After only three years, this portfolio is exposed to more equity risk than their advisor determined was suitable for their client’s goals. A downturn in equity markets would result in a larger drop in overall portfolio value than it would at the original target allocation of 60%.