Investing can be a tough skill to crack. The stock market is changing every day, with thousands of shares being sold and brought every minute. This ever-altering nature of the market results in some unwanted changes in an investor's portfolio which might not align with their needs. Frequent rebalancing of the investment portfolio is a common practice among investors to avoid such conditions. It is important to know the how and why of rebalancing before you begin to consider implementing it.
What is the rebalancing of the investment portfolio?
Rebalancing refers to keeping a check on your investment ratio and making adjustments accordingly to ensure minimum deviation from your original risk and reward requirements. It usually involves buying and/or selling a small number of financial assets to regain balance. It is essentially a long-term strategy of investment where the focus is to keep the investment portfolio aligned with the investor's current needs.
Why should you consider rebalancing?
Rebalancing is practised as a discipline among investors to avoid sudden unwanted losses. It reduces the chances of panic trading and allows investors to make conscious investment decisions. It shortens the recovery period required for market crashes and damages in the long term.
An equilibrium of the asset allocation requirements of an investor is maintained according to an individual's changing needs. Research shows that people who actively rebalance their portfolios during recessions have better chances of coping up with market losses. However, rebalancing is not a must. The average annual returns of actively rebalancing investors and those of passive investors were found to be nearly the same in the long run.
Events under which one should consider rebalancing
There is no one-size-fits-all approach to updating investment portfolios. While various methods have been proposed, no evidence suggests that any single approach is universally effective across different age groups and ethnicities. Effective rebalancing requires a combination of both quantitative analysis and subjective intuition, and traders may employ a diverse range of strategies.
Rebalancing may be a smart choice in certain situations to help you stay up with life's changes. The circumstances where rebalancing is a wise move to make to keep your stock in control are listed below.
- Volatile market conditions
Events such as the recession or sudden inflation call for rebalancing the investment portfolio. You should sell stocks that are risky or have business models you do not understand. The risk tolerance capacity at such times is usually low and it is advised to revert to more bonds for lower-risk investments. If your stock-to-bond investment ratio is 80:20, you can consider flipping it to 20:80. However, this is an extreme case of rebalancing. Usually, rebalancing involves transactions of only 5-10% of the assets.
During good market conditions, a rise in stock prices can increase the stock ratio. For example, if you started with 70% stocks, an increase in stock prices may lead to a 75% stock percentage making the portfolio riskier than your requirements. A simple way to rebalance this would be to sell the 5% stocks in exchange for bonds.
- Major life events
Personal life-altering events cause a change in a person's mindset and future goals. If you are getting married, your future needs look different than your present needs, which creates a need for rebalancing your portfolio. The birth of a kid results in reduced risk tolerance of the parent as liability increases. Whereas a divorce may lead to a more carefree attitude and a desire for high rewards, making an investor choose more stocks than bonds. Our reward requirements and risk-taking capacities result from our circumstances and mindset shifts, which alter as timing and conditions around us evolve.
- Emergencies
An accident or sudden diagnosis of a chronic disease alters an individual's life goals completely. You would need more cash to live the rest of your life better. You would only consider future goals a little as the risk tolerance drops close to zero in such cases. It would then seem a good idea to invest in conservative bonds for a safer investment rather than stocks, as a higher rate of return may not be as lucrative now.
- Change in financial goals
Are you planning to buy a house? Or getting a loan to complete your college degree? In such a case, you might need more money soon and your risk-taking capacities are reduced. You may choose to invest in more bonds than stocks for increased liquidity and low-risk investment. On the other hand, getting a new job or promotion increases risk tolerance which may lead to an increase in stock investment of the individual. You may feel brave enough to explore new, risky investment assets in this situation. Rebalancing your portfolio accordingly will help you achieve your immediate goals.
- Change in risk tolerance
How much is too risky for you? The answer to this question changes for individuals with a change in their levels of maturity and age. Young investors might feel brave enough to go for 90% stocks for better financial rewards, while older investors generally go with safer investment options like bonds. You may go all in for bonds for a short period and eventually return to your desired ratio. This is a balance only you can find for yourself.
Conclusion
Portfolio rebalancing is an important practice in the market. Generally, it is advised to periodically monitor your portfolio and analyse your needs to find opportunities for rebalancing. Some experts suggest rebalancing at a fixed interval, like once every 6 months or a year. But this can lead to unnecessary buying and selling of financial assets leading to taxes and fee charges. Whereas other people frequently rebalance their portfolios according to intuition, which negates the benefits of rebalancing in the long run.
Ideally, one should maintain a balance between the two options and check their needs and asset allocation status to ensure a steady investment of their capital.
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