An important part of investing is to occasionally rebalance your investment portfolio. In a previous post we talked about portfolio asset allocation. Your portfolio will be made up of different asset classes such as stocks, bonds, cash etc and the amount of each is your asset allocation.
Portfolio rebalancing is accomplished by occasionally resetting the proportions of each asset class back to their original percentage.
Let’s look at an example
Susan has just won $50,000 in a lottery. After doing some reading she decided that her portfolio asset allocation will be 60% stocks and 40% bonds. To create her portfolio, Susan bought $30,000 (60% of $50k) of a stock index fund and $20,000 (40% of $50k) of a bond index fund.
One year later, Susan checks out the value of her portfolio – the bonds have gone up 4% and the stock fund has gone down 9%. The portfolio is now worth $48,100.
Susan notices that now the stocks make up 57% of the portfolio instead of the original 60% she wanted. The bonds are now 43% of the portfolio instead of the original 40%. Susan decides to rebalance her portfolio so the asset allocation is the same as when she started.
To accomplish this she must sell some of the bonds and use the money to buy some stock fund. To calculate how much bonds she has to sell, she takes the new portfolio value ($48,100) multiplied by the bond allocation (40%) = $19,420 which is how much she should have in bonds. Since she now has $20,800 of bonds she has to sell ($20,800 – $19,420 = $1560) of bonds and buy $1560 of the stock fund. Then she will then have 60% stocks and 40% bonds.
What is the purpose of rebalancing?
- Potentially increase returns – By selling asset classes that have risen in value and buying other asset classes that have dropped you are selling high and buying low.
- Maintain risk profile – Susan decided that she wanted a 60/40 allocation – if she never rebalanced then it is possible that her allocation (and investment risk) could change from her intended levels.