Why should you rebalance your portfolio?
There are many reasons to cite why it is imperative that you rebalance your portfolio on a regular basis. By incrementally rebalancing your portfolio, you can lock in gains yielded from over-performing asset classes.
Additionally, rebalancing is key as it gives you the chance to buy under-performing asset classes while prices are low with the view to take advantage of that asset class’s potential future value appreciation.
You’re not only protecting your upside, but you are reducing your potential downside as well. Sometimes, you may be taking on more risks than you originally intended. Rebalancing your portfolio will bring your risk levels back to their original types.
Frequency of Rebalancing
The frequency in which you should rebalance your portfolio is very conditional and depends a lot to your circumstances. No two investors are exactly alike so their rebalancing habits will probably be different from each other.
Some investors choose to rebalance on a fixed, time-based schedule, such as quarterly, semi-annually, or annually. Other investors rebalance once they see their asset allocations have deviated from their target allocations.
Rebalancing is a very important tool in maintaining the risk level within your investment portfolio. There are a lot of benefits, such as locking in capital gains, acquiring assets in lower prices, optimizing portfolio diversification, and resetting your portfolio to initial target allocation.
Diversification and Rebalancing
Diversification is your best defense against the risks in specific company, sector, industry, or geography. When you assign target weights to each asset class in your investment portfolio, you exert some control over the total portfolio risk-reward characteristics.
One of the most appealing things that hook investors toward diversification is ensuring that they don’t have all of their money in the worst performing asset class.
Of course, there will always be some of your assets in the worst performing class, and you can never have all of your assets in the best performing asset class.
Theoretically, sector weightings would remain static. On the other hand, you actually fund the investments; the various sectors will begin to diverge in performance. Therefore, to hold the risk-return characteristics of the portfolio would grow.
Markets have a tendency to revert back to the mean. They usually move in different directions and can also overshoot both ways. Eventually they reverse to the mean.
Rebalancing minimizes the volatility and captures additional return. It enforces a policy of sell high, buy low, by systematically paring investment gains and redistributing the proceeds to underperforming assets.
When those positions reverse, you capture incremental gains. The more diversity there is between the segments, the higher the volatility and the higher the gains.
A rebalancing policy can be frustrating and counterintuitive to an undisciplined investor. We know from watching cash flows in investment markets that far too many investors chase recent events, buy high sell low, repeat the cycle until they got no money left and then ask themselves why they can’t make money in the capital markets.